Investing is simple. Build a balanced portfolio of total market index funds instead of endlessly chasing the best performing actively-managed mutual funds or investing in individual stocks. Index funds simply capture the different asset class returns that are there for the taking. For example, the return of an S&P 500 index fund will mirror the overall return of the S&P 500, minus a small amount for investment costs, maybe 0.05% or less. Index funds mimic the return of other asset classes such as the U.S. small cap market, U.S. large cap market, U.S. total market which includes both large, mid, and small cap, real estate investment trusts (REITs), international developed and emerging markets, as well as different bond markets. There’s an index fund for nearly every asset class.

Just Hitch Your Wagon to the World Economy

With index funds, you’re just hitching your wagon to the world economy at rock bottom investment costs. You’re also tapped into the collective wisdom, productivity, innovation, and hard work of the entire U.S. and international corporate markets. In other words, you’re both part owner of all the publicly-traded businesses around the world (stocks) and are loaning your money to business and governments across the globe (bonds). You can do this with only three or four index funds. It’s astonishing really, that just a handful of index funds will provide such massive global diversification at very low cost. Below are some thoughts about investing with index funds, actively-managed funds, and individual stocks.

Why Pay More? 

Index funds are dirt cheap. For example, the expense ratio of a total U.S. stock market index fund – which holds all U.S. companies, both large and small – is usually around 0.05% or less (the expense ratio is what the fund company charges you to invest in the fund). Compare this to the average expense ratio of actively-managed funds of about 1.5%. You might think, “What’s the big deal? One and a half percent doesn’t sound like much.” But let’s think about it: if the long-term, inflation-adjusted return of the market is 5%, an expense ratio of 1.5% would eat up 30% of your after-inflation return. A 0.05% expense ratio would only cost you about 1% of your real return. And this assumes the return of your actively-managed fund matches the overall market return – most fall short.

Other Unnecessary Costs

And this only uses the expense ratio for comparison. Actively managed funds generally have high turnover of their holdings, sometimes in the 100% per year range, meaning that the entire portfolio of stocks was sold and replaced with new stocks during the year. So much for a long-term approach! This turnover comes with high commissions and other costs. All of which can easily add up to another 1% or more in addition to the expense ratio. Plus, some actively managed funds charge a 12b-1 fee to help pay for marketing. Because index funds (especially the total market funds) hold all stocks and don’t actively trade, and don’t charge a 12b-1 fee, the expense ratio is really all you pay to invest.

A Predictive Indicator

The expense ratio is the only predictive indicator of a mutual fund that we can know ahead of time. Invariably, over the long term, the lowest cost funds return the most to its shareholders. As founder of Vanguard John Bogle says, “Costs matter!” And they do – more than we realize.

Become Tax Efficient

“Total market” index funds, such as the total U.S. stock market index and total international stock market index, are very tax efficient and are a great way to invest in a taxable account. Because they hold all the stocks in the index’s asset class, they aren’t constantly buying and selling stocks, and thus avoid generating distributed capital gains. While you’ll pay tax on dividends each year, the capital gains in a total market index fund essentially grow tax-deferred until you sell. For an actively-managed fund, however, the mutual fund manager might buy and sell stocks held by the fund during the year. The capital gains generated during the year are then distributed to you, as part owner of the fund, where you likely re-invest them back into the fund, much like re-invested dividends. But, similar to re-invested dividends, the tax on these distributed capital gains is to be paid by you each year, even though you haven’t sold any shares of the mutual fund itself. Total market index funds mostly avoid these distributed capital gains.

Harness the Wisdom of the Market

By design, index funds capture the returns of all asset classes that are there for the taking. One advantage of a total market index fund is this: they harness the collective wisdom of an army of stock analysts who work day and night to evaluate the long-term earnings potential of companies. The overall price of the stock market is therefore the collective wisdom of all stock analysts – a giant collective brain – and the market value changes as future earnings projections for each company in the stock market change over time. This collective wisdom can be bought cheap by investing via index funds.

We’ve All Done It Before

It’s tempting to seek out and buy actively-managed funds with the highest 1-, 5-, or 10-year returns. We’ve all done it before. The problem is our eye is only drawn to these funds after the fact. We need a time machine to actually capture these returns. Yet there is no guarantee that these funds will do well going forward. Most actively-managed funds revert to the mean, which means that a period of higher-than-normal returns is followed by a period of lower-than-normal returns, with overall total long-term returns approximating the market. Most investors, attracted by the high initial returns of a hot mutual fund, invest at the top only to ride the fund back down as it reverts to the long-term mean. The result? Annualized returns far below the overall market return that was there for the taking all along. Actively-managed funds can also significantly lag the market over the long term because they have a lot of transaction costs and high expense ratios that act as a stiff headwind.

Concentrated Stock Portfolio – Not Worth the Risk

What about beating the market by holding a concentrated portfolio of maybe 15 to 20 stocks? Sure, holding a concentrated portfolio of great stocks will certainly beat the overall market, which includes both great and lousy stocks. But it’s easier said than done. Why? Because within the total market, the number of great stocks is far less than the number of lousy ones. Most individual stocks significantly lag the overall market average. So, the likelihood of owning a handful of winning stocks is small, given that the pool of winning stocks in the total market is also small. So instead of beating the market with a concentrated portfolio, you’ll likely end up underperforming the overall market, perhaps by a lot. Meanwhile, the overall market return was there for the taking all along, via a simple, inexpensive index fund.

Individual Stocks – Really Not Worth the Risk

What about holding just a few individual stocks in your portfolio? The above argument also holds here, of course, even more so because you now own just a few stocks. Remember, when you buy an individual stock, you’re placing your money in a company with an unknowable future. Sure, it would have been great to invest a large chunk of money in one of the few stocks that have had annualized returns of 25% or more over the last 20 or 30 years. But these companies only catch our eye in hindsight. Investing in these great stocks at their inception is extremely difficult simply because we can’t predict the future. Most of these companies, given slightly different circumstances, could just have easily gone under, never to be seen again.

As I write this, Chipotle stock is down 25% because of e-coli and viral outbreaks at some of its locations. A friend of mine invested in the juice company Odwalla. A few months later, some people got sick from a batch of unpasteurized juice. The stock tanked. Volkswagen stock is way down this year because some engineers inserted a cheat code in the emissions testing that wasn’t discovered until recently. The point is, these events are unpredictable, and with just a few stocks in your portfolio, you could be in for huge losses. Possibly huge gains also, of course, but the primary reason we invest is not to get filthy rich, but to not be poor. It’s best to tilt the odds in your favor and just own the entire stock market. The overall long-term return should be generous enough to provide a comfortable retirement.

It’s true that some of us get lucky and tell our story about how we got rich on one great stock. But what you don’t hear are stories from those who bet big on a stock and lost it all, or significantly lagged the overall market return. It’s not worth the risk.

An Easier Way

If you’re looking to goose your overall long-term returns, why not just increase your percentage of stocks by say, 5% to 10% if you have some leeway in your stock/bond split. It’s much simpler than spending time analyzing stocks as you try to increase the return of your portfolio’s stock allocation.

A Little Humility

A parting thought. It’s important to realize when you’re buying or selling individual stocks that, in order to succeed, you need to know more than the person on the other side of the trade. But that person is very likely someone from Goldman Sachs, PIMCO, CalPRS, or some other investment firm or pension fund, where small armies of well-educated, highly-motivated individuals work 80 hours a week with support staff and access to data, CEOs, and computer software that you and I can only dream of, all with the goal of knowing as much as possible regarding a company’s future earnings potential. These “institutional” investors make the majority of trades in today’s market, so chances are good that you’re trading with them. So, ask yourself the question: Why are they willing to sell me their stock at this price? Why are they willing to buy my stock at this price? What do they know that I don’t? A little humility will go a long way here.

A Reasonable Approach

The most reasonable approach for most investors is to get out of the stock and mutual fund picking game altogether. Build a balanced, globally-diversified portfolio of index funds, rebalance when necessary, and stay the course. That’s it. You should spend about 10 minutes a year on your investments. What’s rebalancing? It’s just maintaining your original stock/bond split, which forces you to sell the asset that has done well and buy the asset that has lagged behind. You’re therefore “selling high and buying low” as well as keeping your portfolio risk in check by rebalancing to your original asset allocation.

When to rebalance? Rebalance back to your original stock/bond split if things drift by 5%. For example, say stocks do better than bonds over a period of time and you’re now at a 75/25 split (assuming you started at 70/30). Just sell some of the stock funds and buy some bond funds to get back to 70/30. There’s no tax consequence of rebalancing in a retirement account – IRA, 401K, etc. – but keep rebalancing in a taxable account to a minimum, if at all. You’ll get hit with realized capital gains taxes each time you do. If you’re still adding to your taxable account, try to direct new money into stock or bond funds as a means to “rebalance” to your desired asset allocation.