Investing can be exciting, scary, and intimidating. Throw in the fact that there are so many options and it’s easy to feel lost and just avoid it altogether. So let’s break down two easy ways to start investing: individual stocks vs index funds.
If you’ve watched movies about Wall Street you probably imagine investing to be something like this: A wild flurry of activity and excitement as millions of dollars exchange hands every second.
No wonder so many people think that investing is fast-paced, exhilarating, and complex. But that’s not what investing is actually like. The investors at large investment firms read research reports and crunch numbers all day while listening to music on headphones. The offices are quiet and you can hear the buzz of the AC units.
It’s a world away from running around waving papers at the NYSE.
While you may want to put all of your money into a few individual stocks and make aggressive investments — high risk, high reward — this is the exact opposite of how you should approach investing your money. The #1 move you can make, especially in the long run is to invest in low-fee index funds.
Relative to having a complex portfolio, it can seem too simple to only need 1-3 index funds or ETFs, but we’d rather be rich than fancy.
Index Funds Protect You Via Diversification And Extremely Low Fees
Investing should be boring in the sense that it should be simple and on autopilot. All you have to do is pick a couple of index funds, invest money into them regularly, and hold them for as many decades as you can. Voila!
You’ll have the most success with a long-term buy and hold strategy, and index funds are the perfect recipe. Index funds, like Vanguard’s VTSAX, are diversified so you get exposure to many different companies and industries. It also comes with an expense ratio of 0.04% which means that you’d only pay $3.33 per month if you had $100,000 invested. This is an astonishingly low level of fees, which means you’ll have more of your money working for you, instead of going into someone else’s pocket.
Being A Smart Investor Is Easier Than You Realize…
In our well known post about why you shouldn’t pick individual stocks, we highlighted the fact that the majority of investors will not beat the market average. This includes professionals who get paid a lot of money to analyze and pick stocks FULL TIME. The average professional doesn’t even beat the market consistently, so don’t gamble and learn it the hard way.
Our natural tendencies are either to be afraid of investing and sit on the sidelines, or to go all-in and make big bets on companies we think will crush it. If you spend hours working to make enough money to save and invest, it’s easy to see why you’d want to make sure you get as much money out of your investments as possible. But by swinging for the fences, you’re more likely to strike out.
Whether you are not investing enough (or at all) or cherry picking individual stocks, both will lead you to make less money than you would have by following a simple buy and hold strategy using index funds over a long time horizon.
Even The Pros Prefer Index Funds
Having studied finance at both Harvard and Wharton, we know many many people who have gone on to work as investors at the largest investment firms in the world.
The one thing all of these very talented and opinionated people agree on — use index funds. While their jobs are to pick individual stocks, the vast majority of their personal wealth is invested in index funds.
But you don’t have to take our word for it. Even Warren Buffett, the fabled investment guru, recommends index funds as the best investment. In 2007, he put his money where his mouth is and bet a hedge fund manager one million dollars that an S&P 500 index fund (an index fund comprised of stock from 500 of the largest companies) would outperform a group of hedge funds over a period of 10 years. The index fund rose an average of over 7% per year, while the hedge funds only averaged 2.2% per year. The index fund easily destroyed the portfolios of the “pros.”
And remember, investment firms hire the best and brightest minds in the world to work around the clock to scrutinize, analyze and select what they believe will be the best investments. This group of geniuses still couldn’t beat the index fund.
… But It Takes Discipline And Courage To Tune Out The Noise
Every time you read the news online or turn on the TV, it seems like you hear headlines about companies whose share price has skyrocketed. Even at the water cooler at work, you might hear a colleague talk about a new stock they bought last week that is just killing it for them.
It’s easy to think, “Wow, that stock rose 15% in a single day! I missed out by not buying that stock earlier.”
But you also don’t hear about the majority of stocks who are underperforming or just staying flat. And your work friend is probably embarrassed to admit that he also lost thousands of dollars on a bad bet.
As a society, we love to celebrate the big winners and ignore the losers. This leads to a bias in our minds that pushes us to want to chase the winners. We also suffer from recency bias, and we tend to make decisions with a short-term focus, even without realizing it.
The data shows that trying to time the market (basing your decision on when to invest on your feelings about whether now is a good or bad time to invest) and picking individual stocks will cause you to make bad decisions.
Yet so many people still do it. It’s because it takes an incredible amount of discipline to make a plan and stick to it. Even when it will result in your making the most money, it still takes discipline and courage to follow your plan!
If You Try To Pick Winning Stocks, The Fees Alone Will Kill You
By some calculations, the cost to own individual stocks can be up to 3% per year. This is from trading commissions, taxes, and fees. Due to friction and transaction costs of buying and owning individual stocks, a low-cost all-market index fund is guaranteed to outpace the returns earned by individual stock investors.
What this means is that you’ll have to outperform the market average by 3% to make buying individual stocks worth it. Chances are you won’t even beat the market, so beating it by 3% would make you a world class investor who should be managing money professionally. And let’s face it, that’s
probably not the case if you are reading this. And that’s okay, because you’ll be able to beat the pros by investing using index funds anyway.
So What Should Someone New To Investing Actually Invest In?
We both love the investment philosophy espoused by the late Vanguard Founder Jack Bogle. He invented index funds and has written one of our favorite books on learning to invest.
As an investor, you’ll want to focus on an S&P 500 Index or Total Market Index. These two types of funds have a correlation of 0.99, so it’s not a big deal which one you go with. To see which specific index funds you can invest in, you can check out some of the leading funds here.
To see which funds you should include in your portfolio, you can see all of the important asset allocation information you’ll need here.
Free Your Time To Focus On What Matters Most To You
As if we needed to give you another reason to choose a simple investment plan, you should focus your limited time and energy on what matters most to you. Unless you love to pore over financial documents day in and day out, you probably have better things you can do with your time. Whether you have a hobby you love, or a family you adore, focus on that.
If You’re Dead Set On Picking Stocks, Set Aside 5% Of Your Portfolio
If you can’t bear to live with a simple, proven, passive investment philosophy and you MUST gamble by picking stocks, cryptocurrencies or other speculative investments, don’t risk everything you have. Just don’t do it.
Just use 5% of your money, and don’t put more money into these investments. You might feel like a hotshot if you beat the index funds in the first few years, but remember that you should be focused on a 30 year period, and the data shows indexes are the way to go!
In 30 years you’ll wish you would’ve just left everything in the index funds, but you’re the one who has to stomach your decisions.
A Simple Investing Strategy Will Build A Solid Financial Foundation For Your Family
Just remember that while it may seem boring or too simple to buy and hold indexes for a few decades, you’ll be glad you did that when you can enjoy the money in the future. Those smart investments will help pay for your dream vacation, a retirement free of financial stress, and your kids’ college tuition.
It’s hard to think of anything more exciting than providing financial freedom to yourself and your loved ones.
And lastly, don’t worry if you feel way too overwhelmed to handle all of this on your own. There’s a ton of awesome low-fee financial advisors, like Facet Wealth, who can guide you and handle it all for you.