For new investors

Early in my economics career, I didn’t pay much attention as some of my friends and relatives got started in investing. I didn’t know what they were being sold.

Later on, professional interests and consulting took me into the areas of insurance and investments. As I expanded my research, my friends and relatives began to ask me to read the statements they got from their brokers and investment companies. Then I was astounded to find that they had been sold inappropriate investments!

At first, I thought it was just bad luck — that they had happened on a broker, or adviser, or financial planner, who got them into the wrong assets.

It has now happened enough times that I have come to believe that many new investors are getting bad advice. Oh, it’s not that they’re getting defrauded — it’s just that they’re settling for lower returns and greater risks than they have to.

And why did this happen? Too often, because they sat around waiting for investment ideas to come to them. The ideas came in the form of a “cold call” from someone with an asset to sell — and a commission to collect.

The best investment ideas won’t seek you out. You have to seek them out. The good news is that the best investment ideas are quite simple.

If you’re a new investor, I encourage you to read through the information on this site before committing any money. And don’t trust anyone who pressures you to invest before you’re good and ready.

The key

There is an investment strategy so powerful that Nobel laureates in economic science employ it — but so simple that you can use that same strategy with a minimum investment of only $250! That strategy is:

Buy and hold index funds.

Wait! Don’t go! There are usually two responses to this, and both are wrong. One response is “I’ve heard all this before.” The other is “That’s too complicated for me — I don’t even know what an index fund is.” Here’s why they’re wrong:

I have corresponded and spoken with many people whose reaction is “I’ve heard all this before.” They haven’t. Most often, they have been fed some half-baked slogans against index funds, and that’s all. I have yet to meet a fully informed investor who believes that it’s easy to top the results of buying and holding index funds.

If you think this is too complicated to figure out, read through just a few more paragraphs below. I think you’ll change your mind.

First steps

Before you ever start investing, there are some first steps that you need to take. My book, Getting a Grip on Your Money, will show you what to do in some detail. Briefly, your object is to get your finances in order so that you can leave your invested money alone. You have to give it time to work; it won’t do much for you if you’re always snatching it in and out of the market.

You’ll need to establish some goals, get control of your budget, and get your insurance in order first. If you haven’t done any of this, then read my Chapter 1 (“Declare Victory”), the first of the steps to simplify your finances and prosper. But don’t wait too long! Time is on your side when you invest, so invest early and often, even if it’s not a big amount at any one time.

Indexing basics

Key fact: A mutual fund can invest in stocks by pooling the money of individual investors, then in effect buying stocks on their behalf.

There are lots of good reasons to buy many different stocks rather than just one or a handful. But if you set out on your own to buy a set of stocks, you’ll face brokerage commissions and other expenses. Especially for small investors, this is why a mutual fund is often better then directly buying stock.

When you send your money to a mutual fund, the fund pools your money with that of many other investors, then puts the money into the stock market. You share in the gains and losses of the fund, according to how much money you have put in.

Key fact: Typical mutual funds incur a lot of cost trying to find stocks that will return more than the market (“beat the market.”).

Some mutual funds are actively managed, meaning that their managers try to pick stocks that will do better than the general market, or “beat the market.” It’s costly to hire analysts and trade frequently trying to beat the market.

How do they know when they succeeded in beating the market? They calculate how well their fund did, then compare that with how well an index of stocks did. An index is a collection of stocks. Indexes are averaged using different methods, but the intent is the same: to indicate how “the market” is doing.

For example, the Dow Jones Industrial Average is an index made up of 30 stocks. The performance of the Dow Jones is widely reported and you can easily calculate whether you’re “beating the Dow.”

You could make your own holdings duplicate the performance of the Dow Jones by buying small amounts of the 30 stocks in the Dow, in the same proportion they’re in the Dow. Of course, you’d spend a lot on commissions and transaction fees.

Key fact: An index fund avoids the cost of trying to beat the market, by just matching the market.

The Standard and Poors 500 is a collection of 500 big stocks. You could duplicate its performance, too, just by buying small amounts of those 500 stocks in the same proportion they’re in the index. But you would have to pay the commissions and fees associated with buying 500 different stocks! That would be impractical for a small investor.

Here’s where an index fund comes in. As a special kind of mutual fund, it pools funds from you and other investors, then invests the money in the stocks that make up an index. Because it has millions of dollars to deal with, it avoids the high commissions and fees that would be faced by an individual investor. Better yet, it can easily invest in 500 or more stocks.

So if you invest in a Standard and Poors 500 index fund, you’ll get something like the average return of those 500 stocks. Some will do well, some will do poorly, and you’ll get the average. What’s so good about that?

Key fact: An index fund gives you average returns at a below-average cost. That’s why index funds usually beat conventional actively managed funds.

What matters to investors is a fund’s net return. If a high gross return is eaten up by big expenses, that means a low net return — your bottom line. With an index fund you get average returns, by definition. But you get to keep a bigger part of those average returns, because your fund hasn’t incurred big expenses trying to beat the market.

Key fact: In most years, index funds outperform more than half of the actively managed funds.

Sometimes conventional actively managed funds do well. Their managers spot good stocks, buy them up, and hold on to them long enough for superior returns. But they incur expenses in doing this. In most years, these funds don’t do well enough to outperform the indexes.

There’s an online service that checks the performance of actively managed mutual funds periodically. Check it out yourself here. You’ll see that it’s typically a less than 50-50 shot that an actively managed mutual fund will outperform its benchmarks.

Key fact: It is very difficult to find any investment strategy that outperforms buying and holding index funds.

This is one of the most obvious facts among those who have carefully studied investment markets. The more you know, the more likely you are to see the advantages of holding index funds. Nobel laureate William F. Sharpe is the author of financial market theories that highlight the advantages of indexing. Sharpe was asked whether he invests his money in keeping with his own academic work:

Q: Do you invest your own money in broadly diversified stock index funds?

A: I certainly do.

Q: Do you try to pick individual stocks or time the market?

A: No. I invest in various funds covering bonds, large stocks, small stocks and international stocks.

(Source: Interview with William F. Sharpe in Classrooms and Lunchrooms, Spring 1992.)

On the other hand, people who know less about financial markets are likely to underestimate the advantages of indexing. It’s hard to call index fund investing a “secret,” but it’s surprising how many people get inferior returns each year because they don’t know about it.