I later polled readers as to why they had not started investing outside of a 401k. And now we’re hitting each of the reasons why. The first part in the series dealt with the question of whether you should pay off debt or invest. The second on how to start an online broker account like Zecco or TradeKing. And the third on how to get over the fear of investing.

In this fourth part, we’ll discuss investing theory, particularly why I prefer passive index investing over any other strategy.

Now that you have an online broker account, you’ve funded it, and you’re armed with knowledge and motivation to not let your money sit in a hole in the ground, it’s time to get out there and trade like a pro!

Not so fast…

The Market is Dominated by Institutional Investors

According to John Bogle, the founder of Vanguard, institutional investors own 70 percent of American corporations, up from 35 percent in 1975. An institutional investor is a person or group that manages a large pool of money – such as a hedge fund, mutual fund, pension, bank, or insurance company. Why should that matter to you?

An institutional investor’s job is to get good returns for the people who are giving them money to manage. As a result, they have resources available to them that an amateur like you or I do not.

They have:

• insider knowledge (legal or otherwise)
• ability to negotiate on their trades
• technological trading tool advantages
• time & knowledge: it’s 100% of their focus
• the ability to visit companies first hand, to see what they do and talk to their executives
• the ability to heavily influence the market

We have none of that.

Even if we spent 40 hours a week studying every stock we wanted to trade in and out of, we’d still be at a disadvantage to them.

So don’t do it! To buy and quickly sell (trading) stocks, is like saying, “the price of these stocks, mostly determined by institutional investors, is wrong and I know better when to buy and sell than they do”. While that may very occasionally be true, 99.9 times out of 100, it is  not.

From personal experience, I have tried this strategy and failed massively with it. Occasionally, I made some quick money. But more often than not, I lost money, and whether I profited or lost, it was very stressful. I was watching that ticker go up and down multiple times every day, and my mood would swing based on whether a stock was in the green or red at that moment. Quite addicting. Kind of like gambling. And not a healthy way to live.

A Better Investment Strategy

So, I’ve basically shot down stock trading. Kind of depressing, isn’t it?

Don’t let it be – there is a better way. It’s called passive index investing. And it’s not sexy or thrilling, but that may be just what the doctor ordered when it comes to making money.

To explain what passive index investing is, I’ll first need to explain what an index is.

A market index measures the value of a group of investments, pooled together. Much like a mutual fund, it is a way to diversify through investing in a number of different securities (stocks, bonds, etc.).

For example, one of the more popular indexes is the S&P 500, which is a committee selected group of 500 large cap (market value) stocks, mostly domestic, that are meant to resemble the market as a whole. Another example of a market index is the Russell 2000, which includes 2000 small cap stocks.

You’ll also find indexes that measure different sectors of stocks such as international, health care, real estate, REIT’s, and just about any other way you can group stocks.

Passive Indexing

Passive indexing is investing in market indexes through one of two vehicles – an ETF or index fund. In their simplest sense they are both meant to diversify, track an index, and be a low cost alternative to actively managed mutual funds.

So how do they perform?

Actively Managed Funds Vs. Indexes

We’ve established the many disadvantages that amateur investors are going to have versus institutional investors. But how does passive index investing perform against institutional actively managed mutual funds?

Let’s take a look. This should be eye opening. What you see here is % of U.S. equity funds that were outperformed by their comparable index over one, three, and five years.

Source: Standard & Poors CRSP

Enlightening! In not one category did an actively managed fund classes outperform an index over the last 1, 3, or 5 years. And in some cases, more than 80% of actively managed funds were outperformed by the index.

This has historically almost always been the case. Mutual fund managers are humans, just like you and I. Even though they have more tools and resources available to them, they are still prone to error and making subjective emotional decisions. They are good, but are they as good as the market as a whole? Not often.

Index Investing Strategy Takeaways

I’m obviously a fan of index investing. You’re free to make your own conclusions and invest how you see fit and your mileage may vary on how this strategy performs (in other words, invest at your own risk and get the opinions of others). However, index investing has some clear advantages that you should consider:

• it’s passive: it doesn’t take much work or research to buy and let it sit for a while
• it’s diversified: your risk is much more spread out than a comparable mutual fund and definitely more diversified than a handful of stocks
• it’s low stress: because it’s diversified, you’ll sleep better at night
• it’s cheaper: than managed funds b/c expense ratios are lower
• performance: as evidenced by the table above, indexes, on average, outperform managed funds

What’s not to like about that?

Passive Index Investing Discussion:

• What do you think of passive index investing? Is it the investment strategy you use?
• Have you traded in and out of stocks? How has that worked for you over the long run?
• Does everything I’ve presented here make sense? We’re moving into the complex world of investing and it’s hard to cover in one post what entire books have been dedicated to.

Related Posts:

• 10 Free Financial Services
• Zecco Review
• TradeKing Review

How to NOT Invest Like a Pro (and beat them) with Passive Index Investing is copyrighted by 20somethingfinance.com without consent to republish.

I later asked readers why they had not got started investing outside of a 401k. The first part in the series dealt with the question of whether you should pay off debt or invest. This part will deal with how to actually start a discount online brokerage account.

When I polled readers, 18% said that the reason they have not invested is they didn’t know how to start an online broker account. Hopefully this post will do an adequate job in removing that barrier.

What is a Discount Online Broker?

A discount broker differs from a full-service broker in that YOU make the decision on what to invest in and actually execute the trade on your own. That may sound scary at first, but it’s really not so bad.

There are plenty of discount online brokers out there that have helped drive the cost of trading for amateur investors down significantly over the years. A discount online broker is really all you need. Full-service brokers charge exorbitant fees and don’t necessarily have your best interests in mind.

What Can you do Through an Online Broker?

There is a pretty long list of things that you can do through a discount broker, including:

• Putting your money into a money market account. If you leave your cash sitting, most will offer a nominal savings rate, much like a bank.
• Investing in a CD.
• Buying and selling stocks.
• Buying and selling stock options.
• Buying and selling index funds and other mutual funds.
• Buying and selling bonds.

And it’s relatively cheap to do all of them. Stock trades at most discount brokers are $7 or less and many offer no-transaction fee mutual funds, index funds, and ETF’s (more on what each of these is down the road…).

To put it simply: an online broker is a one-stop shop for you to invest your money in just about anything.

The Best Online Brokers: A Comparison

To get started, you need to pick a broker. There are a lot of good ones out there. Most offer relatively cheap trades. Some charge annual fees. Others have high minimum opening contributions. Some have better customer service and trading tools than others. Depending on your situation, the best discount broker for you might vary.

I generally look for accounts that don’t charge BS maintenance or inactivity fees or annual fees. I also look for low costs to trade stocks and funds and an easy to use interface. Here are a few of my favorites (none of these have inactivity or maintenance fees, and only 2 have annual fees):

TradeKing:

I have both my Roth IRA and Traditional IRA with TradeKing. TradeKing does not charge fees on their IRA’s and stock trades are only $4.95 each. Check out my TradeKing review for a full run-down.

• Stocks: $4.95/trade
• Mutual Funds: $14.95/open
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee
• Promotion: Reimbursement of up to $150 in transfer fees.

Zecco:

I have an investment account with Zecco because they offer $4.95 stock trades. They once offered 10 free trades per month if you had a balance over $25K, but they no longer do that, unfortunately. Check out my Zecco review for more on them.

• Stocks: $4.95/trade
• Mutual Funds: $10/open
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: $30 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

Scottrade:

I have had investment accounts with Scottrade. They have always maintained a flat $7 trading fee while others have shifted their fees around to gain new customers. One nice thing about Scottrade is that they have over 500 local branches that you can visit.

• Stocks: $7/trade
• Mutual Funds: $17/open
• Minimum Opening Deposit: $500
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

OptionsHouse:

OptionsHouse has the lowest prices of the group at $3.95 for stocks and $9.95 for mutual funds. Don’t let the ‘options’ in the name scare you. You can do all of the standard stock and mutual fund investing with Optionshouse that you can elsewhere. They aim to make a platform that is friendly to options traders.

• Stocks: $3.95/trade
• Mutual Funds: $9.95/open
• Minimum Opening Deposit: $1,000
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee
• Promotion at the moment: Open a new IRA and get 100 free trades and up to $125 in transfer fees. Use promo code IRA FREE. Or you can open a non-retirement account and get a free Dell computer monitor.

Vanguard:

My 401K is housed with Vanguard. What I really like about them is they have an extensive list of very cheap index funds and ETF’s under their brand and they don’t charge you for trading in and out of them. If you want to invest in their index funds and ETF’s and have a large enough balance to avoid the $20 annual fee, then Vanguard is a great choice.

• Stocks: $7/trade, branded ETF’s & index funds are free
• Mutual Funds: $35 (if you go with Vanguard, just invest in their funds for free as they have the best index funds and ETF’s out there)
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: Vanguard charges a $20 account fee on IRA’s and other accounts if you have less than $50,000 in assets. If you have more, there are no fees. There are also $0 inactivity fees.

Schwab:

Much like Vanguard, Schwab carries a number of low cost branded ETF’s that they don’t charge you to trade in and out of. Their trading prices are otherwise the highest of the group, at $8.95 each and $49.95 to buy AND sell mutual funds that are not their brand. Don’t go with Schwab unless you intend in investing in their funds.

• Stocks: $8.95/trade
• Mutual Funds: $49.95/open & sell (excluding Schwab funds, which are free)
• Minimum Opening Deposit: $1,000
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

How to Start an Online Broker Account

Now that you’ve picked out a broker, you’re probably wondering what steps you need to take to actually open an account. Check out the minimum opening deposits required, which I listed in the previous section. Note that buying into a mutual fund is usually more prohibitive than actually opening your broker account. Many mutual funds require you to have an opening investment of $1,000 to $2,500. Stocks and ETF’s don’t have these requirements.

Once you have that sorted out, the steps are generally as follows:

1. Create a login and password.
2. Choose the type of account you want. For most of you, it will be an individual investment account (non-retirement), a traditional IRA, or a Roth IRA. You’ll then be asked whether this is a cash or margin account. Since trading on margin is risky, you’ll want to select ‘cash’ 99.99% of the time.
3. You’ll then have to fill out a ton of personal information about yourself including marital and income status, your social security, previous investing history, etc. This information is required by federal law when you start a new broker account, so everyone has to do it, despite how invasive it may seem.
4. You’ll have to fund your account. Most online brokers allow you to do this in a few different ways: via ACH withdrawal from a bank account (usually free to do), via a wire transfer (your bank usually charges for this), via a transfer from another broker, or via check. Note that most, if not all, brokers accept cash or other form of payment.
5. After you fund your account, there is usually a clearing period of up to a week for a background check and for the funds to clear.
6. That’s it. As soon as your funds are cleared, you’re ready to invest!

Estimated time to complete the application and open an online broker account is usually under 15 minutes. It’s relatively straight forward. The hard part is waiting to invest your funds until they have cleared.

Now What?

You’re probably wondering what to do now. I will go through investing basics in upcoming posts, but I can only take you so far and can’t give specific investment recommendations. Start becoming obsessed with learning how to invest. In the meantime, move your funds to a money market account that will earn you a little bit of interest while you figure out what to invest in.

One step at a time. Open your online broker account first!

How to Start an Online Broker Account is copyrighted by 20somethingfinance.com without consent to republish.

He’s become so good at it that most sports bookies will not take his bets.

Billy Walters Is Better at Calculating the Odds than the Odds-Makers

How has he done it? An insane amount of data. He has used consultants to compile databases that predict outcomes and betting lines for games. And his team has done it so well that they’ve been able to out-predict the professional odds-makers in Las Vegas. He considers what the data is showing for each game, compares it to the actual betting line, and then makes a call of how much he wants to bet on each game.

And it has worked for him. Billy Walters claims that he has never had a losing year. I’ve embedded the interview for you to watch, or you can check out the Billy Walters Interview on 60 Minutes site.

My Gambling Caveat

Before I continue with this story, let me give the caveat that I am not advocating professional gambling in any way. Billy Walters is one exception to the rule, and it took an entire team of data consultants and sports experts to develop his system in order to beat the odds. The fact that he’s become famous and well respected in sports betting circles highlights how rare his case is. Continue reading for the true moral of the story here.

Billy Walters Compares Wall Street to Las Vegas

Where this story took a very interesting turn is when Walters began comparing Las Vegas to Wall Street.

Here is the dialogue between Billy Walters and 60 Minutes reporter, Lara Logan.

“I’ve been swindled out of quite a bit quite a bit of money on the stock market. And I bought a lot of Enron stock once. And I got swindled. I bought a lotta WorldCom stock, got swindled. I bought a lotta Tyco stock. I got swindled,” he told Logan.

His disdain for Wall Street is one of the reasons Walters decided to talk to “60 Minutes” – a chance he says to make the point that the gambling world is not as shady as most people think.

“I ran into a lotta bad guys, a lotta thieves. I mean, they’d steal the Lord’s Supper. But I can tell ya, percentage-wise, I ran into many more with suits and ties on than I have with the gamblers,” he told Logan.

“So you would say that the hustler from Vegas got hustled by Wall Street?” Logan asked.

“There’s no doubt about it,” Walters replied.

Why was this so interesting to me?

Billy Walters, the most revered sports better in history – a man who methodically pours through data and has never lost over the course of a year in over 30 years of GAMBLING, has been absolutely taken to the house when trading stocks on Wall Street. He’s not the only one. I’ve covered Mark Cuban’s Wall Street rants in the past.

The Takeaway: If Billy Walters and Mark Cuban, both with insane amounts of money, resources, business knowledge, and inside connections can’t succeed by trading stocks on Wall Street, how can you or I expect to? If you’re ‘making bets’ on stock trades, odds are that you will not succeed. The ‘house’, or in this case professional traders and insiders, will win 6 times out of 10. Slow, steady, low-fee, diverse investments like ETF’s and index funds are probably the only hope the amateur investor (your or I) has.

Related Posts:

• Index Funds vs. ETF’s
• Index Funds vs. Mutual Funds
• Zecco Review
• TradeKing Review

Billy Walters: The Most Feared Sports Better in History Tells 60 Minutes why he Avoids Wall Street is copyrighted by 20somethingfinance.com without consent to republish.

Let’s take a look at index funds and compare them to actively managed mutual funds. It’s important to understand the distinction between the two, because you may have the option of both within your employer sponsored retirement plan. In order to truly understand index funds, you need to first take a step backwards and discuss what they are ‘cloning’ – stock market indices.

What is a stock market index?

Stock market indices measure the composite value of a group of stocks. Indices can be chosen through a set of rules or hand selected by committees. One of the more popular indices is the S&P 500, which is a committee selected group of 500 large cap (market value) stocks, mostly domestic, that are meant to resemble the market as a whole. Another example of a market index is the Russell 2000, which includes 2000 small cap stocks. You’ll also find indexes that measure different sectors of stocks such as international, health care, real estate, REIT’s, and just about any other way you can group stocks.

What is an Index Fund?

Index funds are a type of mutual fund that attempts to mimic the performance of a stock market index. Like a mutual fund, index fund share values are based on the net asset value of all of the stocks they have invested in. Rather than its holdings being regularly bought and sold through managed trades, index funds periodically change investments based on a set of rules or infrequent committee selected changes. A lot of them take the human decision element out completely.

The first index fund was created in 1975 by Vanguard founder John Bogle. Some believe that Bogle’s philosophy was based on the book A Random Walk Down Wall Street by Burton Malkiel, which argued that one cannot consistently outperform the market averages. To this date, Bogle (now retired from Vanguard) and Vanguard remain strong advocates for investing in index funds, and Vanguard is now the second largest mutual fund company in the world.

Why Index Funds are Better?

Proponents of index funds point towards data that shows that they consistently outperform their actively managed mutual fund peers due to the following reasons:

• Usually they have lower management fees (because they aren’t actively managed).
• They trade much less, so turnover ratio is lower. As a result capital gains taxes can be lower.

Comparing index funds to mutual funds often times will make them look favorable. There are mutual fund managers out there whose goal is to meet the market indexes, not consistently outperform them. Because they’re actively managed, their fees are higher and their turnover ratios are higher.  Also, in general, there are some horrible mutual fund managers out there. It makes sense to check their histories before you purchase any of their shares.

A Real Life Comparison of Index Funds versus Managed Mutual Funds

My opinion is that you should take advantage of what is offered to you. Vanguard is my employer’s 401K plan administrator and within my plan I have the option of both index and mutual funds. Let’s take a real life look at an index fund versus a comparable mutual fund within my 401K plan.

Index fund – Vanguard Total International Stock Index (VGTSX): expense ratio = 0.27%, no manager, has outperformed the MSCI EAFE international stock index in four out of the last five years.

Actively managed mutual fund – Artisan International (ARTIX): expense ratio = 1.21%, manager is Mark Yockey who started with the fund in 1995 (good longevity). ARTIX has only outperformed the MSCI EAFE international stock index in two out of the last five years.

The Results

Over the last five years, VGTSX has outperformed ARTIX with a total return of 146% to 100% (with almost 1% lower management fees). This is a significant difference. In this case, being presented with these two funds for international exposure, I would opt for the index fund (VGTSX) every time. However, if I was doing the same comparison within a personal IRA and had other actively managed options to choose from, I would do my research and look to see if I could find an alternate actively managed fund with a lower expense ratio, low turnover, a seasoned manager, and better returns than ARTIX and VGTSX. One needs to look no further than DODFX, which returned 189% over the same period of time, with a team of 9 managers and only a 0.66% expense ratio.

You’ll find a number of investors who invest solely in index funds because they buy into the Bogle rhetoric that index funds are superior in every way in the long run. In many cases, they are. However, there are always exceptions and you should do your homework.

If you have the option of choosing between the two, take a look at the results of the mutual fund managers available to you. When presented with limited options, I have opted for index funds. I’m starting to see the Bogle way, myself.

Related Posts:

• What is an ETF?
• What is Passive Index Investing?
• How to Start an Online Broker Account?
• How to Make a Stock Trade

Should I Invest in Index Funds or Managed Mutual Funds? is copyrighted by 20somethingfinance.com without consent to republish.