Note: Make sure you check out the rest of the series on personal investing.
Picking individual stocks may be fun and exciting, but it usually generates a much lower return than simply investing in low-cost, index mutual funds.
Four Options
If you’re going to invest in stocks, you basically have 4 options:
- Pick Stocks Yourself. You can decide, for yourself, in which individual stocks you’ll invest.
- Use a Broker. You can pay your stock broker a fee (i.e. commission) to pick stocks for you.
- Invest in Mutual Funds. You can pay a mutual fund manager a fee to actively select stocks for you. The annual fee is typically 1% – 2% of your investment.
- Use Index Mutual Funds. Index mutual funds simply invest in most or all stocks in their respective market index. They don’t pick stocks, so fees are much lower, typically 0.05% – 0.50% each year.
Picking Stocks is Like Gambling
Here is a key point: No one consistently picks winning stocks. Read that sentence again, and let it sink in. Even investment professionals—including stock brokers and mutual fund managers—can’t consistently pick winners.
In a sense, picking stocks is like gambling. It can be exciting, and sometimes you even win. But over the long run, you likely lose more than you win. (How do you think they pay for those fancy casinos?)
And paying someone else (e.g. your stock broker) to pick stocks for you is like paying someone to go gamble for you. It is basically throwing money away. Your stock broker may be a wonderful person, and may provide valuable advice about how to manage your finances, but they possess no special, consistently accurate insight regarding the future price of any particular stock. Remember that brokers make money on your trading activity (buy or sell), not on whether you achieve a good return on your investments.
Active Mutual Funds
Mutual fund companies hire managers whose job is to actively select and invest in stocks for a large group of people. Typically these managers charge a fee of 1% – 2% of your asset base each year. So if you invest $100,000, they will charge you a fee of $1,000 – $2,000 each year.
As a group, it is impossible for these mutual fund managers collectively to beat the market, because they are the market. Professional investors (e.g. mutual fund managers) account for about 90% of all stock market trades. So as a group, mutual fund managers earn the market return. But since managers extract an average 1.5% fee, mutual fund investors earn 1.5% less than the market, on average.
As a result, very few mutual funds beat the market return despite the hefty fees investors pay (in hopes that the mutual fund will beat the market). According to one study, only 2% of mutual funds significantly outperformed the market over the 30-year period, 1972-2002.[1]
Approximately one third of mutual funds outperform the market in any single year. But as the time frame lengthens, the fraction of mutual funds that beat the market declines. For 10-year periods, only one quarter beat the market; over 25 years, only one tenth beat the market; and over 50-year periods, only about 5% beat the market. So your odds of picking a successful mutual fund, i.e. one that beats the market over the long term, are quite small.
You might think, “I’ll just pick a fund that did well last year.” But studies show that last year’s mutual fund ‘winner’ typically underperforms the following year. It is just as hard to predict which mutual fund will win as it is to predict which stock will win!
Index Mutual Funds
One way to successfully invest is with no-load, low-cost index mutual funds. (A ‘load fund’ charges an up-front fee of as much as 6% of your investment. Avoid such funds.) Examples of index funds include Vanguard’s Total Stock Market Index fund (ticker = VTSMX) or Schwab’s S&P 500 Index fund (SWPPX).
Index funds don’t bother trying to identify winning stocks; instead, they aim to achieve the market return simply by investing in most or all stocks in their respective market index (e.g. small companies, or growth companies, or foreign companies). Their fees are typically much lower, about 0.05% – 0.50% each year, because they don’t need to hire expensive stock analysts. Index fund investor generally achieve very close to the market return (something most mutual funds don’t achieve) at a much lower fee.
Still not convinced? The book, Common Sense Investing, explains that mutual fund investors typically achieve a return much lower than the market.[2]
For comparison, the average low-cost index fund return was about 12%. The point is that investors are better off to: i) invest using low cost, no load, index funds; and ii) hold them for the long term. For more on this simple index fund investment strategy, I highly recommend the short book titled The Elements of Investing, by Burton Malkiel and Charles Ellis.
[1] Charles D. Ellis, Winning the Loser’s Game: Timeless Strategies for Successful Investing, 4th edition (New York: McGraw Hill, 2002), 104-105.
[2] John C. Bogle, The Little Book of Common Sense Investing (Hoboken, NJ: John Wiley & Sons, 2007), 44, 51.
About the Author
With a BS degree in geophysics, I took a job exploring for oil for a major energy company. I was able to save money, but knew absolutely NOTHING about how to invest it. Didn’t know what a stock was, how the price was set, how to buy a share, etc. So … I headed back to school part time—primarily to learn about stocks and bonds—and eventually earned an MBA in finance (which the oil company put to great use).
I’ve maintained a continued personal interest in investing, and read some outstanding books that have helped refine my investing strategy and goals over the last three decades. I’ve been with Leggett & Platt since 2000, where my professional responsibilities now include strategy, investor relations, financial communications, and analysis. But for 13 years I’ve also served as Chair of the Investment Committee that oversees our pension and 401k investments. Given that latter job role, employees sometimes ask me how they might start investing. These brief articles explain one approach that novice investors might take.
The opinions expressed by contributors are theirs alone, and do not reflect the opinions of Leggett & Platt (full disclaimer).