Primer on sensible investing
- November 7, 2009
- 4 comments
- Posted in Investing, Latest Posts
After the panic and crash of 2008, many investors decided that they had too much money in stocks. Maybe so, in some cases. But if you switch entirely to bonds or bank accounts, your retirement nest egg won’t grow, over the long term. In fact, its buying power will shrink, due to the pernicious effect of inflation. Any money you won’t need for 10 to 15 years or more should generally be invested in stocks—your best hope for capital gains. Here are some tips:
Buy stock-owning mutual funds, not individual stocks. It’s well known that stocks have never lost money (so far!) over 15-year periods and rarely over 10-year periods. But that encouraging news is based on the performance of the stock market as a whole, measured by Standard & Poor’s 500-stock average. All it shows is that the total market is probably safe. No individual stock in that market is safe! Think about Enron, WorldCom, Lucent, and AIG, to mention a few extreme examples.
When you buy an individual stock, you don’t really know what’s happening inside that company. You say to yourself, “It’s a great company,” but how is it actually doing? It might have problems that management isn’t addressing; competitors might be cutting into an important line of business; profits may be rising but profit margins (net profits divided by sales) might be going down; a new technology might threaten to eat the company’s lunch; there might even be fraud. By the time you find out, the stock will be down—even if the market average is going up. There’s a greater chance of a windfall in an individual stock but also a greater chance of a ruinous loss. You can’t predict.
Only the total market produces the historic long-term returns that investors aim for (about 9 percent since 1929, with dividends reinvested; about 10 percent since 1990). You can hold the total market by buying index mutual funds.
Buy index mutual funds. An index fund follows the market as a whole. For example, take an S&P 500 index fund. It holds all the stocks in the S&P average, so it copies the market’s performance minus costs. There are index funds for international stocks (covering the developed countries), emerging markets (Southeast Asia, Latin America, Eastern Europe), small company stocks, real estate stocks, bonds, and other types of investments. The Vanguard Group, www.vanguard.com, has the largest assortment of index funds. For the best performance, you want a fund with the very lowest costs. That means buying from a no-load group (“no load” means no sales charge). The largest such fund groups are Vanguard, Fidelity, www.fidelity.com, and T. Rowe Price, www.troweprice.com.
Why index funds are better than managed funds. A managed fund is run by an investment manager, who picks individual stocks to buy. His or her goal is to beat the performance of the market as a whole. That’s a false hope. Dozens and dozens of studies have shown that the vast majority of managers do not beat the market over time. They might look good for a few years, which is usually when investors buy. But then they fall behind. A managed fund charges higher fees than you’d pay for an index fund, and you’re probably not going to do as well. An assortment of index funds is the better buy.
Split your investments between stock funds and bonds. The younger you are, the more of your long-term investments should go into stocks. Here’s a handy rule of thumb that I’ve always followed: Subtract your age from 110. The resulting number tells you what percentage of your money to hold in stocks. For example, say you’re 40. Subtracting 40 from 110 gives you 70. That means that 70 percent of your money should be in stock funds with the remaining 30 percent in bonds. Or say that you’re 60. Subtracting 60 from 110 gives you 50—so 50 percent of your money should be in stock funds with the rest in bonds.
Buy target-date mutual funds. You’ll often find them in 401(k)s, or you can buy them for your Individual Retirement Account. Target-date funds contain a mix of stocks and bonds appropriate for people of various ages. The funds are labeled by year—for example, 2020, 2025, 2030, and so on. You pick the year that’s closest to the year you’ll be 65 and invest the bulk of your money there. Your fund will be heavily in stocks while you’re still young. As you age, the fund will reduce the amount it invests in stocks and increase its investments in bonds. You can also hold the fund past age 65. Its holdings will gradually get even more conservative. Eventually, it will be invested almost entirely for income. The beauty of target funds is that you don’t have to keep track of your mix of stocks and bonds. The fund does it for you, automatically.
Tags: bonds, index mutual funds, international funds, investment diversification, mutual funds, retirement nest egg, stock market, stocks, target-date funds
Jane,
In your interview on KCTS you said go with domestic (such as S & P 500) and international index funds. Above and in your book you tout target date mutual funds. My wife is 64 and I am 62. We have everything in various Vanguard funds. So my question to you is do we convert to index funds (domestic & foreign) or go with a target date mutual fund?
Thanks – Mike
Vanguard’s target date funds invest in Vanguard index funds, so you’d have both.
I’ve heard that target funds can be very expensive. Is that true?
Thanks,
Perkins
Target funds sold through brokers and commissioned planners are expensive. Those sold through the major no-load groups, such as Vanguard, are not. They’re also not expensive in 401(k)s.