Updated: 1/24/2010 9:22 PM ET|
The couch potato’s path to riches
Passively managed portfolios that aim to merely to match the performance of the broader market often outperform those run by managers trying to bigger returns.
Getting into the investing game for the first time can be intimidating. New investors might think they have to spend hundreds of hours learning about stocks and mutual funds, and constantly watch their portfolios to make sure they're on track.
Hooey, many experts say.
"To think that by trading individual stocks you're going to beat the stock market over a couple of decades is beyond ludicrous," says Bill Schultheis, a principal of Soundmark Wealth Management and the author of "The Coffeehouse Investor," both of which subscribe to the philosophy of creating and holding a diverse portfolio of mostly low-cost index funds to ensure growth and eventual wealth.
"In the past 20 years I have not spent more than 20 minutes total on my portfolio, and I've outperformed 95% of people," Schultheis says. "That is because I never trade, and I stick with an investing philosophy that fits with my life."
Too good to be true?
So how do you create your own couch-potato portfolio, one that works for you while you spend time doing the things you do best, like enjoying life?
Increasingly, investing experts advocate index-based exchange-traded funds, or ETFs. These are basically mutual funds but they are traded like stocks throughout the market day. And they follow benchmarks.
There are ETFs that follow the economies of individual countries, or broader economies such as South America's or the developing world's. There are also ETFs that follow stock exchanges, commodities or specific industries like health care or oil and gas. The value of an index fund that tracks Taiwan's economy goes up and down with that country's economy. Same with a fund that follows gold; as the price of gold goes up, so does the ETF.
Recently, a few "active" ETFs have been introduced. These are exchange-traded funds that are managed by investment professionals, and they come with higher expense ratios in return for promises of higher returns.
Index funds are similar except that they are bought from mutual fund companies and are purchased and priced just once a day, at the close of trading.
Owning and holding an index-based fund is considered passive investing, since the fund just follows its benchmark. Any changes are automated and infrequent, and it has been proved over many decades that economies and sectors will grow over the long term.
Because changes to index-based funds are limited, the cost of managing them is low, giving these products a big advantage over actively managed mutual funds. Active management requires expensive teams of managers and analysts who constantly evaluate a fund's holdings, and buy and sell to maximize your investments.
Index fund expense ratios -- or the percentage of the fund's assets that pay for the cost of running the fund -- average about 0.25%, a really good bargain, and ETF ratios are often even cheaper. Meanwhile, expense ratios for actively managed funds run about 1.5% and can exceed 2%. Because these fees eat up your profits, it costs you much more to own an actively managed fund than it does an index fund, a big reason index funds frequently outperform mutual funds.
The other big reason is that, according to many experts, the market nearly always outperforms human beings.
Both theories are supported by numerous studies. These include a 2009 report by Mark Kritzman, the president and CEO of Windham Capital Management and a professor of financial engineering at M.I.T.'s Sloan School of Management, who found that over 20 years, factoring in expenses and taxes, index funds earned an average of 8.5% per year, compared with 8% for actively managed mutual funds and 7.7% for hedge funds.
Apply these figures to a $20,000 deposit in a retirement account, and, over 20 years, you would earn more than $9,000 more with an index fund than an actively managed fund.
Philosophically, many professional investors became discouraged with actively managed funds and their managers when these products -- just like passively managed funds -- lost their shirts in the 2008 crash. Experts argue that you stand to earn similar returns at lot less cost with a passive product, which has a far smaller expense ratio.
"We were paying actively managed mutual funds quite bit money, and they didn't do a good job of putting on the brakes in 2008," says Kevin Kautzmann, a financial planner with EBNY Financial in New York.
Mike Alfred, the chief executive at BrightScope, which researches and rates retirement plans, believes strongly in index funds.
"The absolute best investment strategy is low-cost index options, and if anyone tries to tell you differently, they probably have a vested interest in selling you a product," Alfred says.
How less is more
So how does one build a no-brainer portfolio?
The first step, experts agree, is to plan and save adequately for retirement with the help of regular, automatic contributions to a 401k, individual retirement account or brokerage account.
From there, go as diverse as possible with the lowest costs you can find. Though it may seem impossible, you can achieve this with as few as three index funds, Alfred says.
Classic choices might be a fund that broadly tracks the U.S. stock market, like Vanguard 500 Index Investor (VFINX) fund; a total bond market fund, like Vanguard Total Bond Market Index (VBMFX) fund; and a global stock fund, such as Vanguard Total International Stock Index (VGTSX) fund.
Basic ETFs include SPDR S&P 500 (SPY, news), which measures large-capitalization U.S. stocks; and PowerShares QQQ Trust (QQQ, news), which tracks the Nasdaq 100 Index ($NDX), the largest domestic and international nonfinancial companies listed on the tech-heavy Nasdaq exchange. Commodity ETFs that track precious metals, grains or energy are also a good place to start.
As your wealth grows, add index funds focused on individual sectors, regions and countries. The key is to choose the right funds, then hold tight for the long term. No fiddling with your portfolio every day.
To prove the importance of keeping your mitts off your brokerage account, two University of California, Berkeley, finance professors studied more than 66,000 investors between 1991 and 1996 and found that the most active traders -- those with monthly turnover of greater than 8.8% -- earned an average return of 11.4% while the market returned 17.9%. They also found that buy-and-hold investors with inactive accounts banked 18.5%.
No path to stock picking?
Does this mean that there is no place for playing the market -- buying on a hot stock tip or selling based on doom-and-gloom headlines?
Not necessarily, says Barbara Roper, an investor protection lobbyist with the Consumer Federation of America. Feel free to count your armchair Jim Cramer fantasies as a pastime -- as long as you can afford it.
"If you view (stock picking) as entertainment, and if you do it with money you can afford to lose, and not your retirement plan, people can have whatever hobbies they choose," Roper says.
Knock yourself out.
At the time of publication, Emma Johnson did not own or control shares of any funds mentioned in this article.
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