There are many different approaches an investor can take in managing their money. Some approaches are hands-off and require little effort to maintain the desired asset allocation. Other approaches are more time intensive and might require daily or weekly management. There are other approaches that fall somewhere in-between. The key to success is to define your investment style.
No matter how you decide to invest, you need to have an investment philosophy. It should be part of your financial plan. Without having direction, there is just too much noise to misdirect you on a daily basis. Every hot investment tip will sound like a good idea. That will lead an investor to try to chase performance.
It is up to you to decide how you want to invest your money. Some approaches are considered more favorable than others because they are tax efficient, cost very little, and allow investors to capture average market returns. There are approaches that rely on investment professionals to try to beat the market. Some investors feel confident that they can manage their own selection of individual securities and want to pick their own stocks. There are also Robo-Advisors that investors can use to manage their investments.
When it comes to trying to invest to build wealth, there are countless avenues for investors to explore. There is passive investing, active investing, crowdfunding, and countless other forms of ventures to invest in. The purpose of this post is to cover some of the most common forms of investing where the transactions can occur with the click of a mouse.
Index funds are what their name implies. An index fund is a mutual fund that is composed of stocks that track a specific index. For example, if you buy a share of an S&P 500 index fund, you are buying an investment that is made up of the largest publicly traded U.S. corporations.
There is little actual management and turnover with index funds. That is what makes them cheap and tax-efficient. A management team is not required. There are very little trading and turnover within most index funds.
There are index funds that track large-cap stocks, small-cap stocks, international stocks, and bonds. There are index funds that hold every publicly traded stock in the world. There are also index funds that track individual sectors or sub-asset classes such as consumer stables, natural resources, technology stocks, and other sectors.
An investor can keep it simple and buy three index funds like the total U.S. stock fund, total international stock fund, and total bond market fund that would allow them to own every publicly traded stock in the world. An investor can slice and dice and break it down into many different funds and build a custom portfolio with different tilts. There truly are limitless possibilities.
Managed funds are like index funds. They invest in a basket of different stocks or bonds. The major difference is that they do not track an index. They have a fund manager or team of managers who try to beat a benchmark. For example, a managed large-cap growth stock fund would try to beat the S&P 500 index.
Compared to index funds, managed funds have higher fees. The average expense ratio for a managed large-cap stock fund is 0.99%. The expense ratio for the Vanguard S&P 500 is 0.04%. That is almost one whole basis point.
The goal of the fund manager is to outperform its benchmark. Based on the difference in fees, the fund manager must outperform the S&P 500 by almost 1% per year to just break even. That is very difficult to do. It is getting even harder as the result of the shrinking alpha.
For the fund manager to try to beat their respective benchmark, they need to make trades. They are paid to buy stocks within the fund that they think will outperform. They also must identify the stocks that they think will underperform and sell them.
All of that buying and selling is called turnover. Some managed funds have a turnover ratio of 90% or more of their portfolio annually. If a managed fund is held in a taxable account, all those trades trigger capital gains that are passed on to the investor.
Most managed funds do not beat their benchmark. In 2016, only 34% of large-cap mutual funds beat the S&P 500. It gets worse with time. Only 10% of large-cap mutual funds beat the S&P 500 over the last 15 years.
What happens to the underperformers? Usually, a new manager is brought in to right the ship. If its performance does not improve, it normally merges with another fund.
Investing in individual stocks can be rewarding. If you select the right stock, you will outperform the major indexes. Just look at Google, Amazon, or even Apple.
The problem with investing in individual stocks is that it is hard. Most active mutual fund managers who have unlimited resources cannot consistently do it. It is not likely that an individual investor will outperform the S&P 500 for a decade or longer.
Can an investor get lucky when they buy a few stocks? Sure, they can. That, however, is speculation. Investing is not gambling.
When an investor buys an individual stock, it is a vote of confidence in a company. It is a vote that they know the stock is undervalued compared to its market price. They are making a statement that says they know more about the fundamental business operations of the company and they are positive that it is sure to appreciate.
They do not know any of those details. The individual investor receives their information from the financial media or a stock screener. They are the last to know anything about the value of a stock. The professionals, analysists, and insiders know before the media. They provide the information to the media. The media informs the individual investor.
Robo-Advisors are the new frontier for individual investors. Robo-Advisors are financial management platforms that allow investors to manage their investments based on algorithm-based variables. An investor plugs in their goals, risk profile, and other survey data and Robo-Adviser does the rest.
The technology used by Robo-Advisors is not new. The investment industry has been using it to rebalance accounts since the early 2000’s. It is new, however, for individual investors to have access to this type of asset management technology.
Even though it has been around for some time, it is fascinating technology. Since it is automated and based off an algorithm, there is not much room for human error. Not only can it be used for investment selection, but it can also be used for more sophisticated processes like tax-loss harvesting.
There are some nice benefits to using a Robo-Advisor. They are a much more affordable option than having to hire a human Financial Advisor. The annual fee to use a Robo-Advisor is between 0.2% to 0.5%. That is much more affordable than must shell out up to 2% for a human financial advisor. The minimum amount that is required to invest with a Robo-Advisor is much lower than the standard six-figure minimum that many traditional human financial advisors require.
The above investment styles are just a few of the more popular methods for individual investors. Over the years, my portfolio has become primarily made up of a few index funds. I have invested in a few managed funds but sold off all except one. As far as individual stocks, I have only bought and sold five individual stocks since I started investing. I have not owned any individual stocks since 2004. Many investors in the financial independence community use individual stocks as part of their dividend strategy. As for the Rob-Advisors, I have invested using that technology, but do see its value for tax-loss-harvesting in a retirement account.
What is your approach to investing?
Do you follow any of the methods that I covered or a blend of a few different approaches?
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