Investing and Mutual Funds
One of the best (and best-selling) books on investing is Burton Gordon Malkiel’s A Random Walk Down Wall Street. Now in its 7th or 8th edition, the book makes the case against trying to beat the market or getting lucky in picking the right stock. While one can sometimes beat the market or pick the right stock, odds are that you’ll be wrong more often than right, and the transaction costs are going to wipe a lot of your gains. Instead, Malkiel recommends the same basic strategy he first recommended in 1973:
Diversify your portfolio
Invest for the long-term
Take advantage of dollar-cost averaging
This strategy is based on the assumption that over time, the economy will continue to expand, and the markets will reflect this expansion by increasing in value. Of course, this is a long-term trend, and in the short-term, the markets will rise and fall on a daily, weekly, monthly, or even annual basis. The three components of the Random Walk strategy are intended to flatten out the inherent volatility of the markets to produce long-term gains for the investor.
Diversify your portfolio
Individual stocks are very volatile. As the market follows the next big thing, capital moves from blue-chips to dot-coms to bio-tech to media to bonds and back again in a roller-coaster ride that can often leave the small investor high and dry. However, if you assume that the economy is growing over time, the market as a whole will rise. Think of the market as 3 dimensional space: to avoid being left in one of the valleys of the market landscape, spread out your investments across this landscape. While your gains won’t be as great, your losses, too, won’t be as great. Investing in at least 20 or more different companies in different sectors usually minimizes volatility to a reasonable level. That’s why mutual funds are great. In order to invest in 20 or more companies, the individual investor would have to have tons of cash to buy stocks in each company. By investing in a mutual fund, the individual investor can essentially buy partial shares in these companies, thus lowering the threshold for investing.
Invest for the long-term
This is the time component of the investing universe: over time, the market will rise. Trying to get your money in at a low point and out at a high point could go disastrously awry. There’s no way to tell whether there’s a peak or a valley beyond the short-term time horizon, and in the meantime, moving your money around will incur transaction fees that will eventually eat up any minor gains you may make. But if the market will rise over time, then sitting tight with your diversified portfolio should see corresponding gains and lower transaction costs, provided that you can stomach the dips along the way.
Take advantage of dollar-cost averaging
Just as diversification spreads out your investment over space, dollar-cost averaging spreads our your investment over time. How does it work? Essentially, instead of investing your annual $2000 in January and hoping that you’ve timed it just right, you divide that amount up and invest it over time. Let’s say you get paid every two weeks and want to use part of your paycheck to invest: $2000 divided by 26 is $77. By investing $77 every two weeks, you ensure that you average out the price of your portfolio. So instead of risking plunking down $2000 when the market is high and getting reamed by a dip, you get the average price of all the peaks and valleys. While Malkiel doesn’t explicitly say to invest 20 or more times during a year, I imagine it’s not such a bad strategy. If it works in space, it should work in time.
So why is it called A Random Walk Down Wall Street? It’s based on the idea that no one, not even the professionals, can accurately guage which stocks will perform best. Many mutual funds are actively-managed, meaning that the portfolio changes based on what the fund manager thinks will do well. The Random Walk team argued that the S&P 500 (a market index of 500 companies) historically outperformed 80% of the actively-managed funds and that trying to beat the market didn’t make sense (reminds me of a social psych experiment I once heard about). They set out to prove this by pitting their own portfolio of stocks, picked using the equivalent of throwing darts at a page, against actively managed-funds. 30 years later, their “fund” is outperforming most actively-managed funds. This is mostly due to fund managers guessing wrong as they move the money around, but a significant factor is also due to transaction costs that the fund has to absorb in all the buying and selling.
Picking a fund
So it’s reasonable to say that in picking a fund, it’s best to pick one based on a broad index, such as the S&P 500. The money stays put, and the portfolio only changes when the index is updated (which happens infrequently). Keep your money in this fund for the long-term, take advantage of dollar-cost averaging, and you should see gains over the long-term that beat inflation and give you a healthy return on top.
BusinessWeek also has a recent article that talks about the value of investing in index funds, especially in light of the recent mutual fund scandals.
The other things to watch out for are fees and loads. Every fund is supposed to publish a prospectus which describes the fund’s philosophy, costs, and historical performance. These costs are the most important part of your research (the philosophy should be to track a particular market index, and the historical performance is almost irrelevant). Funds take a percentage of the assets. This is reasonable. However, these percentages can range from .5 to 1.5. If you have a choice, why wouldn’t you take the lower percentage? Since you are investing in an index fund, you don’t need some smart guy to figure out where to invest, which is how some funds try to justify higher percentages. Some funds also charge advertising fees, loads, and other things that eat away at your earnings. None of this stuff is necessary, so look for lower expense ratios.
I’ve got my investments in an S&P 500 index fund at Vanguard. They feature no-load funds, and have one of the lowest expense ratios in the industry. Plus, if you read the Newsweek and Economist articles above, you’ll know they’re not involved with this whole mutual fund scandal, and have, in fact, often called for stricter regulations over funds and the markets. Over the time that I’ve invested in this fund, I’ve seen rates of return as low as -13.9% and as high as 13.4%. Thanks to dollar-cost averaging, my overall rate of return to date is 15%. Not bad.
Investing for Retirement
Who wouldn’t want free money, right? Well, if your employer offers a 401(k) with matches, take advantage of it! My company used to match 60 cents on the dollar up to 6% of my salary. That meant that every dollar I invested instantly saw a return of 60%. My only regret is that I didn’t join the plan earlier. As for the effect on your take-home, it’s not as bad as you think. Your contributions are pre-tax, meaning they’ll be taxed when you start withdrawing money from the fund. For example, let’s say I had $180 to invest every pay period and my effective payroll and income tax rate was 33%. The $180 pre-tax investment would result in a $120 hit on my paycheck. Not only that, but with the company matching 60 cents on the dollar, I would get to invest $288 for every $120 I couldn’t spend on whiskey. Free money’s always a good thing. In reality, my rate of return on my own contributions, including the matches and their gains, has been 74%. Sweet.
Even if your employer doesn’t offer matches, the 401(k) does offer a lower investing threshold. I said earlier that mutual funds offer diverse portfolios for lower investing thresholds than investing directly in stocks, but the truth is that there are still some thresholds. Funds don’t want to spend the money processing every Joe off the street, so they often have minimums to open an account and minimums to add to your account. The 401(k) offers a way to get into the fund without meeting the minimum requirements if you don’t have a bunch of cash lying around. Hopefully by the time you leave your employer, your balance will surpass the required thresholds and avoid any fees for being below the threshold.
No free money?
If you have the cash and your employer doesn’t offer matches, your best bet might be to invest in an IRA. Between traditional and Roth IRAs, I would advise investing in the Roth. The traditional IRA is pre-tax, which means that the investments and your gains will be taxed when you withdraw money at retirement. You’ll get the taxes you paid on the investment money refunded at tax time. The Roth IRA is post-tax, but your investments and gains are not taxed when withdrawn at retirement. You pay a little tax up front, but since you don’t pay tax on your earnings at the end, the Roth tends to be the better deal. The same is true when you pit the Roth against the 401(k). So for me, the choice was basically between free money and higher taxes. The amount of free money offered in the 401(k) outweighed the tax benefits of the Roth.
Again, I’d recommend buying A Random Walk Down Wall Street. The Motley Fool also offers lots of decent advice on investing and other things, like mortgages, credit card debt, etc.