As I walked into Facebook, I met a woman at the entrance who led me to the presentation room. With a sheepish smile she said, “I don’t know anything about investing.” “That’s OK,” I replied. “Most people don’t. They just don’t admit it.”
I’ve spoken at investment companies. I’ve spoken at banks. I’ve also spoken at Blackrock, the world’s largest investment fund provider. You might think that everyone who works at a bank or investment firm understands investing. But that isn’t true. In most cases, investing isn’t part of their job. Like you, nobody taught them how to invest when they were in school.
Plenty of people believe you need to follow economic news and pick individual stocks if you want to be a good investor. But that isn’t true. Let me start with something familiar. When you turn on the television or the radio, most days, you’ll hear something like this: “The Dow gained (or dropped) 100 points today, to close the day at blah, blah, blah.”
The Dow Jones Industrials comprises thirty of America’s largest stocks. Now here’s something most people don’t know (if you don’t believe me, please test your neighbors). If someone bought the 30 Dow stocks five years ago, ten years ago, twenty years ago or fifty years ago, they beat the returns of most professional investors. Sound crazy? Of course it does. But it’s true.
The Dow beat the performance of most hedge funds (those fancy products you hear about that rich people own). The Dow beat the performance of most actively managed mutual funds (the funds your bank sells). The Dow also beat the performance of most college endowment funds.
So…if you split your money among the 30 Dow Jones Industrials stocks you would beat the investment performance of most professionally managed money over the next 10, 20 or 50 years, too.
If you’ve followed me so far, you’ve learned something that few employees at your local bank know. So let’s keep going. After some more background, I’ll share a far simpler solution than buying the thirty Dow stocks.
The Dow is just one measurement of how U.S. stocks perform. The S&P 500 is another. All 30 of the stocks that represent the Dow Jones Industrials are also part of the S&P 500. This larger collection, like the Dow, is known as an “index.” The S&P 500 includes 500 of America’s largest companies. Over long periods of time, the Dow and the S&P 500 earn similar results.
The largest collection of U.S. stocks is the Wilshire 5000 index. Despite its name, it includes about 3,500 U.S. stocks. Over long periods of time, it also earns similar returns to the S&P 500 and the Dow Jones Industrials.
But you don’t have to buy dozens or thousands of U.S. stocks if you want to thrash the returns of most professional investors. Instead, you could buy a stock market index fund.
Such funds are available for the Dow, the S&P 500 and the Wilshire 5000. But it makes sense to diversify. That means putting your eggs in a greater number of baskets. In this respect, the Wilshire 5000 makes so much sense. With an index fund that tracks the Wilshire 5000, you would own a sliver of every stock in the S&P 500 and the Dow, plus about 3000 other U.S. stocks.
In other words, by owning a single index fund, you would own a smidge of almost every stock on the U.S. market. But it’s a good idea to diversify even further, by adding exposure to international stocks, too. Such an index includes thousands of stocks from outside the United States. It includes British stocks, Chinese stocks, Canadian stocks, Australian stocks and almost every market in between. Best of all, if you own an international stock market index, you will beat the vast majority of professional investors who trade such stocks full-time.
These claims about beating the pros might sound crazy. But they are backed by evidence. Here’s an example provided by SPIVA. SPIVA compares the performance of professionally managed mutual funds (the products your bank and most financial advisors sell) to stock market indexes. Over the 20-year period ending December 31, 2020, the international stock market index beat 89.35 percent of professionally managed international stock market funds.
The S&P 500 index of U.S. stocks beat 93 percent of professionally managed U.S. mutual funds over the same 20 years.
The past twenty years represented different types of markets, what the industry calls “bull markets” and “bear markets.” Think of a bull as a rising market and a bear as a falling one. In other words, despite rising and falling markets over the last twenty years, benchmark indexes beat most investment professionals. One reason is fees. Professionally managed funds charge high, hidden fees that erode investor’s returns. A second reason is stock selection. Professional fund managers try to pick stocks that are hot and avoid stocks that are not. But despite what we might think, most of them aren’t very good at that. Stock market movements are unpredictable. A professional investor (or perhaps even a braggart you work with) might get lucky with his or her stock picks for several years in a row. But over long periods of time, the relentless index will likely catch and pass them.
Most financial advisors at your local investment firm will pick actively managed funds based on those with strong, past performances. But as SPIVA’s Persistence Scorecard proves, actively managed funds that win during one time period often underperform the next.
If you’re still with me, you now know something most financial advisors don’t. As I explained in this story, research suggests most financial advisors buy actively managed funds for their own accounts, too. In other words, they eat their own bad cooking and then pay the price.
There’s just one more piece to the investment portfolio puzzle: bonds. They don’t earn great returns. But they add stability. These are the angels that prevent you from freaking out when stocks fall hard. And stocks always do, at some point, crash. When stocks fall, plenty of people sell at a low. They then buy back after stocks have recovered. In other words, panic leads them to buy high and sell low. A bond allocation, however, can help keep investors calm.
Below, you can see how a U.S. stock index compares with a U.S. bond market index.
By blending a portfolio of stocks and bonds, investors have higher chances of staying on course (and not panic-selling) when stocks drop.
Now here is, perhaps, the world’s simplest investment solution. You could put your money into an index fund of index funds. For example, with as little as $1000, you could buy one of Vanguard’s Target Retirement funds. Each of them contains a U.S. stock index, an international stock index, a U.S. bond market index and an international bond market index. You can select one based on your approximate retirement date. For example, Vanguard’s Target Retirement 2045 fund includes about 90 percent in stock market indexes and 10 percent in bond market indexes. As investors get closer to retirement age, Vanguard slowly increases the bond allocation. In 2045, such a fund would have roughly 60 percent in stocks and 40 percent in bonds.
You could put such a fund in an IRA (Individual Retirement Account), adding $6000 a year if you’re below 50 years of age and $7000 a year if you’re over 50. Over your lifetime, such a combination of indexes will outperform the vast majority of professional traders on a risk-adjusted basis.
So don’t be intimidated by what you think others know. After all, most people don’t know what they don’t know.
For Further Reading:
Proof that portfolios of index funds beat most hedge funds:
- Has Your Portfolio Beaten The World’s Most Famous Hedge Fund?
- The Embarrassing Side of Buffett’s Million-Dollar Bet
Proof that index funds beat most college endowment funds:
- College Endowment Managers Wanted: Easy Prestige and Money
- Seven-Year old Investor Beats Harvard’s Endowment Fund
More About Target Retirement Funds
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas