We here at MoneyNing.com recommend low cost index funds for the individual investor. Sometimes we write out a good argument, and sometimes we simply state it as fact. This article illustrates what happened with one of our reader’s investment portfolio so you can judge for yourselves whether low cost index funds is for you.
MoneyNing,
I am on the west coast and the US stock market is already open when I get to the office. Sometimes I check the performance of my stocks, and other times I do not (actually, I check it all the time). When I did check stock prices this morning, I noticed that the money in my taxable account went down by 12%. I looked into the details and realized what happened. One of my stocks just reported earnings and the stock went down 20%. Since I had a ton of money in this stock, I was hurt badly. Really bad. Panicking, I sold every share I owned in the stock. I sold my holdings in Apple too because I was afraid Apple was going to down after it reports later that day. I’m really pissed off right now because I checked after hours and Apple is up more than 10% since I sold it. I realized I was being dumb and really want to see if you can recommend some low-cost index funds for me to own since I am clearly not cut out for stock picking.
Regards,
MoneyNing Reader
His story is all too familiar. I made similar mistakes when I first started investing because I too panicked when a stock didn’t go the way I thought it would. The beginning of my investment career was filled with moments of me selling low and buying high because when stocks go down, I will sell and then when they go up, I will buy them again thinking I will miss the boat otherwise. Over time, I managed to learn from my mistakes but the early lessons were very costly.
When stocks go down significantly, some of us almost get this sickening feeling in our stomachs. Sure, any individual stock could go up significantly and boost our portfolio’s performance, but the risk is also very high.
Some people who pick individual stocks don’t even know much about the company. In essence, many of these people are treating the stock market like a casino. Furthermore, many of us don’t have the tolerance to properly manage the emotional roller coaster of individual stock prices going up and down. We end up buying high and selling low because of greed and fear.
Everyone who has individual stocks in their portfolio should examine their risk tolerance not when times are good (when stock prices are soaring) but when times are bad (the day the price drop significantly). Only in adversity can we truly determine our risk tolerance, and thus our asset allocation.
Low-cost index funds on the other hand are much less volatile. No one will become rich overnight, but it is a much more dependable way of investing in equities. The strategy gives us comfort that the portfolio wouldn’t get crushed if something horrible happens to any particular company (e.g. Enron), and will help us better see the long-term benefits of investing in the stock market.
Here are ten more specific reasons why you should invest in total market index funds.
1. Investing in total market index funds is a bet on the future economy.
Since a diversified all market index fund tracks a wide variety of industries, you are essentially betting on the whole economy to continue making money for you when you invest in such an index fund – historically an extremely profitable bet. The real benefit comes when stock values take their routine dive down because it’s much easier to hold onto the securities and not panic sell when the likelihood of the values coming back up is extremely high. Contrast that with owning individual stocks, where any company can turn for the worst and your investment never coming back because of mismanagement or simply changing of the times.
2. This is as close to a set it and forget it approach as investing can be.
And it is the realization that index investing is a bet on the whole economy growing through time that any index fund investor can treat this as passive investing if they want to just ignore the market noise and stay the course through the thick or thin.
Side Note: I’ve been investing in index funds for quite a few years now, and I know that this is the best way to grow wealth for me even if I can beat the index investing on my own because investing any other way takes time. Time away from other activities I enjoy, and even time away from other money-making activities. I’ve made far more than the excess investment gains I can generate by spending that time on my improving my website. Many people can benefit too if they just spend more time working on a side hustle or investing in themselves to propel their own career.
3. It’s been shown again and again that the index strategy beats other ones over time.
You’ll always hear about people who’ve made a killing investing in stock A, or B, but the vast majority of people lose their shirts betting on individual companies. Those who invest in funds pretty much have no chance, because studies have shown over and over again that active funds have a very tough time beating their index fund benchmark in any given year, and the odds get worst as time goes on.
4. You’ll have less stress invested this way.
Knowing that you are betting on the economy as a whole, not needing to look at the values multiple times every single day, and the high likelihood that you are getting some of the best returns anyone out there will ever get is very comforting, especially when times get rough and all the media outlets are touting about the upcoming Armageddon again.
5. Add the potential tax-loss harvesting opportunities and the odds of outperforming shoots up even more.
When an index goes down, an investor who has losses can sell it to offset other gains or take up to $3,000 off income to reduce their taxes. The IRS doesn’t want you to simply sell an investment and buy it right back for the tax benefit, so they came up with a wash sale rule to prevent someone from buying the same or a substantially identical investment within 30 days of selling that security. Luckily, an index fund investor can still take advantage of any losses because they can simply sell an index fund, buy another index fund that tracks a different index but behaves similarly in terms of performance to reap the tax loss while still be fully invested.
6. You can actually pass the portfolio on to someone else to manage and the transition would be seamless.
I don’t plan to ever die, but it’s unfortunately not up to me to decide. One of these days I’ll have to pass the baton to my wife, our kids, or maybe even a third-party advisor if my mental capacity declines due to old age. I don’t know how anyone believes they can have someone else continue their legacy of market-beating returns, but I know that it’ll extremely straightforward for me to tell the successor how to manage our portfolio.
7. The decision to sell with index funds is much easier than individual securities.
I have needed money lately from my portfolio, and I’m only now appreciating how much easier it is to sell my index funds instead of a few of the legacy individual stocks that I still own. Each individual stock go up and down differently, and selling one versus another can have vastly different results. Add to that the different tax cost you’ll have for selling each individual security because you have a different cost basis for each investment and you can quickly see that there’s really no way to know in the short term which one will be the better decision. You end up doing the sell and hope, which sets you up for quite a bit of potential regret.
8. The investments get a step up in basis at death.
All cost basis for appreciated assets gets to be stepped up to market value upon inheritance, meaning that your heirs won’t have to pay taxes on much of the gains of your index funds. Sure, you’ll have to live on your portfolio at some point, but I bet you that the aim of your retirement is to have at least a bit of money left in your portfolio. On the other hand, you expect to buy and sell individual stocks multiple times since industry changes and different industries will outperform in the next few decades. Therefore, an individual stock investor not only has to outperform the index but he or she has to outperform by a wide margin to account for the tax drag as well.
9. There are minimal yearly tax costs.
Fund investors on the other hand will be paying capital gains taxes as well because there are unavoidable capital gains taxes for active mutual funds investors every year.
The huge tax benefit for index funds is most pronounce with Vanguard because the company has a patented way of handling the mutual funds and ETFs share classes of the same index fund to reduce yearly capital gains taxes, but they have been extremely good at keeping the capital gains tax cost of their total market index funds to a minimum.
10. No worries of a huge tax cost if an individual company were to start a long-term decline and you have to sell.
Imagine you bought IBM decades ago, and then the company spends a few decades dominating the computing market and thus giving you crazy good returns. You’ve got this million-dollar position now and life is good, right? But what do you do with the investment now? It’s been years since IBM has been a good investment. Yet, your cost basis is so low you are going to get a gigantic tax bill if you sell. You can wait things out and the company may reinvent itself again, but what if IBM is the next Kodak and your entire investment grinds to $0?
This is actually a lucky scenario because those who bought IBM or any other company that turned out to dominate its respective market right from the beginning made a killing and got really lucky if they held on. But still, what I just described doesn’t sound like a fun situation to be in decades after the initial investment.
Imagine buying any stock now. You can argue that you see a bright future for a company and it’s going to trounce the index for many years, but what is going to happen in a decade? Two decades? There’s simply no way to know what any company will be like in a few decades. And what happens then will greatly determine whether you actually benefit financially from the decision you make today. It’s entirely possible that even a ten-bagger you don’t sell can end up underperforming a simple index through time if things don’t go well for that firm in a few decades. You just don’t know.
You can roll the dice and hope for the best, or you can get the steadier returns while freeing up all your time to pursue other activities.
The choice is up to you.
Editor’s Note: I’ve begun tracking my assets through Personal Capital. I’m only using the free service so far and I no longer have to log into all the different accounts just to pull the numbers. And with a single screen showing all my assets, it’s much easier to figure out when I need to rebalance or where I stand on the path to financial independence.
They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it’s free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.