In the previous post, we looked at my investment philosophy, meaning the principles I use when choosing what to invest in.  Since I am investing for the long-term (retirement) I want stock funds that are easy to understand, have a slow and steady track record, and have minimal fees.

Using these criteria, let’s look at the actual stock funds I invest in and recommend.  In a nutshell, index funds are good and actively managed funds are bad.

What to Invest In

When it comes to the three principles outlined, index funds can’t be beat.  Before explaining how they meet the criteria, let’s talk about what index funds actually are.

A stock index is a listing of the largest companies in the various stock markets, ranked by market capitalization.  The most well known index is the S&P 500, a listing of the 500 largest stocks on the New York Stock Exchange.  These 500 companies account for about 75-80% of all US common stocks.

An index fund is a grouping of stocks that follows one of the indexes (such as the S&P 500).  They invest in stocks proportional to the amount of each company’s stock in the market.  So an index fund would have more of GE’s stock than, say, Apple’s.  If you were to invest in an S&P 500 fund, you would own a little stock of all 500 of the largest companies in the US market.

Index Funds vs. Our Philosophy

So how do index funds stand up to our investing philosophy? First of all, they are simple to understand: I just explained one to you in the preceding two paragraphs.  You are investing in a large group of common stocks.  No alphabet soup here.

Secondly, index funds have the least volatile returns available (of common stock).  In fact, this is where index funds really shine.  Since they are so diversified (across hundreds or thousands of companies), when measuring the return of an index fund, you need only be concerned with how the overall stock market is performing.  The performance of any one company is so small (some even negligible) in the aggregate.  This leads to smoother, more consistent returns.

Last of all, let’s consider fees.  Once again, index funds take the cake.  Since index funds simply track an index, there is no advanced analysis needed when picking stocks to include.  Index fund fees are rock-bottom.

What to Avoid

Now that we know what to invest in, let’s look at what to avoid.  As I said in the beginning of this post, actively managed funds are bad.  An actively managed fund means that some smart person or complex computer software is picking the stocks to include in their funds.  Active managers look at financial statements, stock charts, and Wall Street gossip to help them choose stocks.  In future posts, I will go into detail about the methods that are used, and how ineffective they are for our purposes.

Managed Funds vs. Our Philosophy

How do actively managed funds hold up to our three criteria?  Oftentimes, fund managers will invest in all sorts of tools, regardless of our understanding.  The attitude here is “trust me, I’m a professional”.  Most active managers are buying and selling stocks so often that even if you did figure out all the tools you were putting your money into, a month later it would have changed.

Historically, actively managed funds, in the long run, never outperform index funds.  For stretches of 5- 10- or occasionally 15-year periods, actively managed funds have returned more than comparative indexes.  But in the long-run, active managers have not outperformed index funds.  In fact, many managed funds, following the concept of mean reversion, after a period of outperforming the index go on to underperform.  For a more detailed explanation of this argument, I refer the reader to The Four Pillars of Investing or A Random Walk Down Wall Street.

Actively managed funds are the main culprits when it comes to high and hidden fees.  The reasoning goes that if a smart person or sophisticated computer algorithm is picking your stocks, you should pay them more for their efforts.  Managed funds came up with wrap accounts, 12b-1 charges, and a plethora of ways to take your money whenever you buy, sell, look at or think about (not yet, but they’re working on it) stocks.  Here’s the real kicker with managed funds and fees: Any higher return you may receive from them gets eaten up by the higher fees they charge.

Recap

Let’s go over what we’ve talked about today:  Since I am investing for the long-term, I look for funds that are easy to understand, have a steady track record, and low fees.  Index funds fill all of these requirements, so we love them.  Actively managed funds (ex: mutual funds) fail on all three and are to be avoided.  Now that we have laid the groundwork for our investment philosophy, we can zoom in and look at specific aspects of investing for retirement.

Tags: index funds, mutual funds, stock picking

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