This is the fourth of a multi-part series on how to invest outside of a 401K. The whole idea for this series started when I was asking a group of about 30 co-workers if they invested outside of a 401K, and found out that zero of them did.
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. 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 investment 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.
- insider knowledge (legal or otherwise)
- ability to negotiate on their trades
- technological trading tool advantages
- researching resources
- 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 an active stock-picking investment 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, REITs, and just about any other way you can group stocks.
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? What percent of actively managed funds outperform their index over time?
According to a massive report that looked at the last 20 years,
Nearly 94% of all domestic active stock fund managers had underperformed their respective S&P benchmarks in the past 20 years (through mid-2021). In U.S. small caps, 92.25% of active fund managers lagged the S&P SmallCap 600 benchmark. Even active management’s record in foreign markets over the past 20 years raised red flags. Inquisitive investors might take note that slightly more than 92% of international stock fund managers weren’t able to beat their respective S&P indexes.
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. Despite this under-performance 70% of U.S. fund assets are still actively vs. passively managed.
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 – this may seem boring, but it’s spectacular
- 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 stats 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.
So if passively managed index funds outperform the actively managed funds, how is it that everyone has not flocked to index funds. How is it that these investment bankers are pulling in 7 figure bonuses when they are losing to funds that require no management and costs a small fraction of the costs of the active fund? Can anyone explain this to me?
It has everything to do with leverage. IAMs and Hedge Funds have it, and small individuals generally do not. This means that small gains are maximized by large volume. For example, a hedge fund may underperform a listed index by 1% in realized return, but while that 1% may mean 10 dollars for an individual investor, it more likely that not will mean thousands, if not millions to the hedge fund.
Also… many 401K plans don’t offer index funds. I’m not sure what politics (payouts) are involved in this, but many investors just aren’t familiar with them as a result.
This is true…I have had 3 different financial companies through 4 different jobs since college, and none of those 401k plans offered any ETF options. I really have no idea why that is, other than companies like Fidelity who have a plethora of their own funds they push.
Wow, that seems crazy to me. We don’t have 401Ks in the UK, but the closest comparable products allow investment in tracker funds.
I completely agree. People think they need to be exceptional investors in order to hit their numbers, and this is one area in life that it’s 100% beneficial to be average, ie perform in line with the markets instead of trying to outperform.
When it comes to investing, I am a very aggressive investing who takes a lot of risks because I highly believe in no risk no reward.
I also employ primarily an index funds only approach. I psychologically prefer index funds over ETFs though, so I will stick with those.
I have a small amount of stocks from my employer that I kept last year since the stock price was reasonably low and they have more than doubled in value since then, so I will probably sell them once I have held them for a year and move the funds into a S&P 500 Index Fund. I don’t plan on keeping further stocks from my employer long-term unless, again, the stock price is quite low. Our stock price goes up and down a lot and with the large dollar amounts of future stock vests, I don’t want to chance that – I would rather diversify with an index fund.
I agree. A lot of people I work with just hold on to their options as if it was the conservative thing to do. It’s super risky!
My parents keep telling me I’m crazy for planning to auto-sell my company stocks, but when 20+% of my gross salary for the year comes from stocks, that’s way too much money to gamble on. Some people have the idea of “Why keep any?”, but I feel like keeping that small amount (about $1.5k when they vested) was a good learning experience and individual stock investing definitely isn’t for me!
What about Lifecycle funds? They are set it and forget it investments. I’m not so nervous about investing outside of my 401k. I’m more concerned with my allocation matching my age and goals.
Lifecycle funds have typically done very poorly versus the market and have higher expense ratios. If you truly want to set it and forget it for 50 years, they might be a good fit, but if you don’t mind doing a little bit of work, I think there’s better vehicles out there.
I use one of the target date funds myself, I chose the one that has me retiring in 40 years as opposed to the 30 years it will most likely turn out to be. I want slightly riskier investments since I still have a considerable amount of time until retirement. The expense ratio is a little high for my taste, if it were my post-tax brokerage account, you would never see me invest in these funds. However, they are good for a “set it and forget it” investment strategy. I hate to sound lethargic in regards to my retirement finances, but I dont know that rebalancing my own investments each year is really going to benefit me all that much in the end.
I manage my husband’s 401k. His employer has a handful of index funds and target date funds. Although the options are really limited I like all the options. I have 50% in the s&p 400 midcap index and 10% in each of the following market funds: TIPS, REIT, International, Emerging markets and S&P 500 index. Each of these funds is designed to match a corresponding index although I couldn’t name all of them. I’ve been very happy with this strategy and I have done well over the last 5 years.
I’m naturally very cautious and I feel that buying individual stocks is too much like gambling. Also, when you have very little money to invest, trading fees eat up too much of your investment. I will continue sticking with index funds. They work for me.
I like that idea. I do something similar with Schwab ETF’s. I got some of each of them and feel that it should do well. I’m going to start selling the mutual funds and keep rebalancing as time goes on. I do tend to overweight the international and emerging markets more than most suggest though– don’t trust these US markets.
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.
I’ve just started passive investing. I don’t know that much about stock valuation, and when only 20% of fund managers (who dedicate their lives to stock valuation) beat the market, I’d have to lie to myself pretty good to think that I could outperform them.
I think something important to add about ETF’s vs Mutual Funds is that ETF’s trade with a commission like stocks and many mutual funds are no load. This is important if you like to invest on a regular basis. The ETF commissions could really eat into your returns.
I’m also a subscriber to the random walk theory: the index wins over the long-term.
I also like Justin’s approach. Target date investing is the way my wife and I are saving for retirement. We each have a Roth IRA, me with TRP, and hers is with Vanguard. Automatic rebalancing, reasonable fees, and great diversification.
Very good post here! I also am a proponent/user of passive investing index strategies. I tried investing in individual stocks, and failed pretty badly too.
Well, Jesse Livermore did say that he was mostly cutting out his emotions when he went about trading.
Well, Jesse Livermore did suicide a few years after his wife left him.
But I think there is some sense in having an ability to remain calm even if the numbers are going bad. It speaks of an innate emotional stability.
What a breath of fresh air! I interned with an investment firm last summer and learned about both strategies. I’ve also read Bogle’s book on index investing. It’s amazing how many people just would prefer another strategy. The classic index fund is one of the only dependable strategies over time. And it is the absolute best for those who aren’t super finance savvy. There is nothing not to love about it. I am glad to see that I am not alone in the fight for index funds.
great information this can really help somebody that’s trying to invest in something
Hi, my name is Max. I’m doing a project for my Wealth Building class and I found this very helpful, so thank you.
This is so boring
This is buns