Most articles written about personal finance are terribly flawed. Yes, there are exceptions. There are some fine blogs offering ideas similar to those presented here, but they are few and far between. The experts repeat again and again the same nonsense: I can pick winners for you, so invest with us.
But it's a fool's game. I know this now having listened to expert advice for years and making the usual mistakes.
It's really quite simple. Picking individual stocks contains far too much risk. You might win for a while. There are some stocks that have been riding high for a long time. Yet putting together the perfect basket of stocks over a long time horizon is close to impossible. If you are investing for at least 10 to 30 years or more, consider putting all or most of your money in index funds.
What kind of index funds, you ask? I prefer index funds that track the total market, or at least the S&P 500. Then I would pick the fund with the lowest fees.
This last point is crucial. The higher the fees (known as an expense ratio), the more money your investment company takes and the less that comes home to you. If you are still with a financial advisor, you are likely losing at least 1-2% of your earnings to them, if not more. If a fund is front-loaded, your costs will be even higher. How big a deal is this? I would say this is a very big deal.
Let's say I have an initial investment of $10,000, and I commit to putting in an additional $1,000 a year. I invest in my favorite fund, which is at Vanguard, called the Vanguard Total Stock Market Index Fund (VTSAX). This fund has the lowest expense ratio I know of at 0.05%. It invests in about 3,200 US companies. By the way, this is not a Vanguard commercial; please do your own research and by all means substitute any other index fund that has comparably low expenses.
Choose a total stock market index fund because its performance over a very long time period cannot be beat. Companies come and go, but the overall market always wins. In the long run, the market climbs higher and higher. The short run is a different story. There will be plenty of ups and downs, so perseverance is required. Turn off CNBC and the nightly news because there could be many months or even a few years of negative returns or low returns. The market always bounces back, however, because it desperately wants to! I will write more about this in another article.
Let’s return to my example:
I have invested $10,000 initially into VTSAX and I am adding $1,000 per year with an expense ratio of 0.05%. Let's make the duration of my investment 20 years, and let's pick an annual rate of return at 6%. If you think that's too high, then simply adjust the rate of return, but VTSAX has returned about 8.2% annually in the last decade.
My total expenses in this fund will be $498.
Now let's compare my expenses with investment vehicle #2, say a mutual fund picked by Joe Financial Advisor at Company XYZ. He tells you that the annual returns are going to be great, that this is a very popular fund with leading investment advisors, and so on. Best of all, Joe tells you, the expense ratio is very low at just 1%!
After 20 years of the same inputs as above, you have paid Joe Financial Advisor and his chosen fund a whopping $9,258. You have given up $8,759 compared to investing in the lowest cost index fund.
It's a much worse scenario when you examine an investment horizon spanning thirty years. Using the same inputs as above, my fund will have cost me $1,499 over the entire 30 years. Your investment at this “low” 1% fee will cost you $26,834. The difference in our two costs is $25,335. Do you really want to leave that kind of money on the table?
I am not suggesting that anyone put all their eggs in one basket. I would choose a few other funds that have very low costs, in particular a bond fund with a good yield that offers downside protection against inflation.
Disclaimer: This article is for informational purposes only. I am not offering investment advice.