After researching the subject and my own little trial and error, I came to the conclusion that index fund investing might be my best path to financial freedom. Exactly how to buy index funds and build a proper portfolio is no easy task.
I started investing in the stock markets playing individual stocks (note here the word playing) back in 2013. I had a very good year and made a 30% return but I do not think I would have been so luck year after year. Stock picking can be profitable and thrilling but in most cases but your lucky strike will not last.
In my first year, even after a good profit, I realized that it is a game that you simply cannot win year after year. Just think about it, out of all actively managed mutual funds (run by teams of professionals that analyses the market as a full-time job) a whopping 82% of them did not constantly beat the index over the last decade.
Nearly 89% of actively managed funds underperformed their benchmarks over the past five years and 82% did the same over the last decade, S&P said CNNMoney
When millennials like me are thinking of investing for the next 50 years or so, missing out on a few basis points can really hurt down the line. When choosing your own stocks, your odds are even lower than those funds managers, unless you have access to all the information and analysis they do. That is not something I would like to bet on!
Anyone who wants to retire early should start investing young and should save the majority of their income to quickly become financially independent. Before you start going out there buying every stock your hipster barista says is a sure hit, realize that you just cannot beat the market. Professionals in actively managed mutual funds cannot even constantly beat the market! (89% of them)
Even the averages show a large discrepancy. From 1970 to 1992 (a 22 year period) the average equity mutual fund return was 10.8% while the total market return of passive investors would have been of 12.0%. This represents a shortfall of -1.2% but the actual shortfall was roughly -2.5% given the average annual expense ratio of 1.3% during this full period.
To put it in numbers, a $1000 investment in an actively managed mutual fund would have grown to $5,778.65 after 22 years and a whopping $12,100.31 if invested in a total market index. That is more than double the return of the “professionals”.
The most important lesson I can teach you in investing is; Be patient and believe in the index. Many great fund managers have outperformed the market, some for decades, like Warren Buffett or Peter Lynch. However, those are the exception, the best in their trade, and it is highly improbable to pick those managers. Peter Lynch said it himself:
Most investors would be better off in an index fund. – Peter Lynch
Even the great Warren Buffett stated that his heirs should not try to beat the market and simply invest in index funds. In a recent annual letter to Berkshire shareholders, Buffett stated that after all of his Berkshire shares are donated to charity, take the cash left and just buy index funds.
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers. – Annual letter to Berkshire shareholders.
You cannot control the market
Professional managers charge for their services and frequent trading. They usually advertise a lot, which increases the annual fees and have a high turnover which increases taxes. If you compare the 0.05% to 0.30% fees Vanguard charges to the 1% to 2.5% actively managed mutual funds charge, it’s obvious! (Morningstar found the average fee to be 1.19%)
Index investing gives you diversification in the markets at a very low cost and little effort. Some mutual fund companies are doing everything to get new clients like showing results in such a way to increase advertised returns by showing their best years or comparing to an unfit benchmark.
If you try to pick good stocks or good mutual fund managers, you will quickly find that you are spending a lot of time researching. In addition, when you do make a decision, you will regret it and be anxious when it drops. I have seen fund companies close, freeze funds or dropping drastically simply because of management changes.
You cannot control the market. However, you can control your fees. With low-cost ETFs such as Vanguard’s, your costs can be as low as 0.05% per year! On the other hand, if your portfolio had an average expense ratio of 1.19% in actively-managed funds, you would be giving up quite a lot of to those “professionals”.
Over a 20-year horizon, $10,000 invested in the above index fund would have grown to $65,225.84 if invested in an S&P 500 fund with a 0.05% annual expense ratio. Comparatively, the same investment with an average expense ratio of 1.19%, would have grown to only $52,940.96. This is a cost of $12,284.88. This is without any change in returns, simply a slightly higher expense ratio.
The other beauty of indexing is that it does not require much of your time and it will let you focus on other things. When the markets will drop, you can feel confident that your portfolio is properly diversified and will bounce back up every time. You need to remember that individual stocks or mutual funds do not always recover, but markets do.
Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm. – Annual letter to Berkshire shareholders.
Relax and let it be
For me, I decided to automate my savings and investing and trust my allocation. Indexing can be stress-free and require very little of your time if you want it so. You should look into automatic 401k (or RRSP) contributions with your employer, this automates investing and you might even get an employer match.
I invest in a set allocation every paycheck and I try to stay away from the market news. On this, notice that news outlets are made to captivate the audience and often dramatize everything, the simplest dip and it’s the apocalypse. Patience is a virtue and long-term investments will grow with time.
You can partake in indexing through mutual funds or ETFs that track the index for very little fees. Depending on your country and investment objectives, either option can offer great savings if you take the time to shop around. The best solution is to get a commission-free option with hyper-low management fees such as a Vanguard account.
In Canada, I suggest the TD e-series mutual funds if you do not have a commission-free broker since they do not charge commissions and have a low minimum investment of 100$. However, if you prefer ETFs given their lower management fees, you should look for a commission-free broker such as Questrade and purchase Vanguard Canada funds to save on annual fees.
If all of this sounds too complicated, we suggest Wealthsimple.
Start your automatic investment account today!
Make your savings work for you
The most important thing when selecting investments is diversification. If you have 5 stocks in your portfolio and wish to hold them for 50 years, chances are at least one of them will go out of business and you will be losing 20% of your portfolio in one stride.
The simple way to avoid that is to own a lot of stocks and bonds in your portfolio. You could achieve this by buying hundreds of individual stocks and bonds but this would take huge capital and cost you a ton in trading commissions. However, the easiest way to achieve proper diversification is to buy funds that are composed of thousands of stocks or bonds.
Asset allocation is a key factor in the total return of your portfolio and will help you lower the volatility. The main things you should consider when picking index funds are the total number of stocks held, annual expenses ratio, and ease of use (how easily tradable it is).
- Should hold at least 1500 individual stocks
- Should have a low management fee (0.05% to 0.30%)
- Should be easy to buy and sell at no or very low cost
In Canada, look into TD e-Series mutual funds if you and to invest regularly at no cost or open an account with a commission-free broker like Questrade to invest in Vanguard index funds.
You really only need an allocation of the Total Stock Market (VTI), Total International Stock (VXUS) and Total Bond Market (BND) to have full diversification over multiple economies.
Vanguard Total Market holds 3,757 American companies in small, mid, and large caps which gives you great reach compared to the S&P500 or the Dow Jones index.
Their Total International Stock ETF includes 6,005 stocks invested in over 46 countries. This is great to give you proper diversification in developed and emerging markets. The US has a great history for investors and is still producing great returns but the international investment might be the next big run-up and will diversify your portfolio if the US does not perform as well as it has been.
Finally, depending on your age, you might want to include the Vanguard Total Bond Market index fund which has 7,860 different bonds. Again, holding bonds depends on your age and your risk preference, some hold 100% equity portfolios and do just fine. Some others prefer to keep a portion in bonds to ease the ride. You can see exactly how I invest in my Open Book series.
What is the perfect portfolio?
This is not investment advice, simply my personal thoughts on a good asset allocation for a young investor. There is no perfect portfolio but I look at it in terms of years before retirement; the more time ahead, the more equity you should own.
If like me, you are more than 5 years away from retirement, you should invest mostly in the total U.S. market (80%) hold some international (20%) and no bonds at all. Some go for even more international but I am happy with the exposure I get from American companies that operate overseas and a slight percentage of international ETF.
The reason I invest next to nothing in bonds is that over the long-term, equities have always outperformed bonds and you do not need that security if you are not withdrawing anytime soon. As the time approaches, you might want to go for a 70% total market, 10% international, and 20% bonds to lower the volatility of your portfolio in retirement and be able to withdraw from the bonds when the markets are having a bad year instead of selling equities when they are low.
Going for a 100% equity portfolio will maximize your opportunities to grow your money over the long-term and keeping the majority of your portfolio in equities, even in retirement, will ensure it continues to grow and supports you. You can read more about my views on bonds in a guest post I wrote on GYFG.
Rebalance and reinvest your dividends
Rebalancing has been shown to increase the average returns over time and is quite easy to do yourself. I rebalance once or twice a year by selling my top performers and buying the underperformers to rebalance to my set allocation.
This might seem illogical but rebalancing allows you to cash in your profits and increase your share of cheaper assets. This will keep your allocation on track since a huge might add unwanted risk to your portfolio if it gets out of your comfort zone.
In addition, you should always reinvest your dividends and automate your contributions. This will allow you to invest mindlessly and make the most out of compounding. To put it in more concrete terms, the annualized S&P 500 return without dividend reinvestment has been 5.471% in the last 100 years.
Now, if we compare the same time period (1916-2016) but with dividend reinvestment, the annualized return was 9.875% (calculator from dqydj.net). Almost half of the total returns have come from dividends and if you are investing for the long-term, you should leave it all there and reinvest. You can read my in-depth post about the benefits of dividend reinvestment to learn more.
If you have more ideas, please share in the comment section below. Happy investing, Xyz.