What to Do Instead of Investing in Index Funds

Hey everyone.

Two days ago, I wrote about how investing in index funds ("passive investing") is only something you should do if you're investing for extraordinarily long time frames (i.e. for retirement, which should be 30 to 35 years away). Although I encourage you to go back and read my previous post, I'll reiterate the basic thesis behind my last post. It's that although the S&P 500 (an index or group of stocks that is a gauge for how the stock market is doing as a whole) has a compound annual growth rate of approximately 9% for the past 87 years, returns on the S&P 500 or the broad stock market in general can vary wildly from year to year, as demonstrated by this chart. If you don't have an 87 year time horizon or even a 20 year time horizon for your money, but want to make it work for you so you can reach financial objectives that are 3, 4, or 5 years away - i.e. buying a home, taking a trip around the world, buying a new car - what can you do to reap the benefits of investing in the stock market?

Well, before I tell you specifically what steps you can take, I must remind you that investing successfully is hard work. And it will require your dedication to it. By dedication, I mean that you must be willing to spend at least an hour a day (or 7 hours a week) doing the things outlined below. Come on, you can dedicate at least 4 percent of your week to improving your financial future, right? You can? Great! So here are the steps you need to take:

1) Determine what type of investor you are (a growth investor or a value investor) and then determine your risk tolerance by taking the following questionnaire. Growth investing and value investing are not mutually exclusive, necessarily, but they can be at times.

2) Spend time checking out the websites of stock newsletter subscription services that have thriving investor communities such as Cabot, TheStreet, The Motley Fool, or Morningstar. All of the above-mentioned websites have customer service lines that can help you decide which subscription service is best for you. Use these human resources!

3) After you have decided upon a subscription service that fits your budget and investment style (both of these criterion are equally important), then that's the time to start evaluating the newsletter's picks. When stock newsletters make picks each month, the newsletters usually include a synopsis of the company's financials, industry, and growth prospects. If you are more familiar with an industry that a particular stock recommendation falls into, and you think the prospects for the industry are bright, that might be a company on which you seek out more information. I would also suggest that you act like you're back in college and email the newsletter's editors with any questions. This will accelerate your learning curve when it comes to stock market investing.

4) Once you have your particular stock for each month set, you should dollar cost average into this investment. This way, you will buy more shares of that particular stock when the stock price is lower, and less shares when the price is higher, thereby lowering your cost basis. 

Well, that was a mouthful and seems like enough for today. But come back tomorrow for a "two-fer" when I'll be discussing where to find good information on companies and what metrics to look for, along with the importance of becoming a minipreneur. Until then...

JP $

The Case Against Index Funds/Passive Investing

Hey everyone.

If you've read any of my previous blog posts, you've probably noticed that I generally steer clear of conventional financial wisdom. Not because conventional financial wisdom is wrong - although a lot of it is, in my opinion - but because it's often one size fits all. All of you readers out there have different financial goals. Some of you might just want to develop an extra income to supplement your income from a job that you already love. (Let's call this Goal A.) Some of you, on the other hand, might be striving to become wealthy beyond your wildest dreams such that you don't have to work ever again and neither do your kids. (Let's call this Goal B.) Although I'm not as wealthy as I want to be just yet, I can assure you that the practices one must adopt in order to achieve Goal B are drastically different than the practices one must adopt in order to achieve Goal A.

Conventional financial wisdom - you know, the stuff you hear talking heads spouting on CNBC's personal finance shows or on websites about frugality, getting rich slowly and what not - states that when you invest in the stock market, you should invest in an index fund. An index fund is basically like a mutual fund, but one that has much lower administrative costs (the costs involved with running a money management company). One added benefit of an index fund is that its returns are directly tied to the overall stock market, more specifically whatever "index" (i.e. the S&P 500, the Down Jones Industrial Average, or the Russell 2000) it tracks. And since most mutual fund managers can't consistently achieve a rate of return that is higher than these broad indices, the argument goes that it's better to try to "match" instead of "beat" the market.

These talking heads are right in that it IS hard to "beat" the market. And they're right that index funds cost less than mutual funds, and that it's easy to lose money by actively trading in and out of stocks, just on the cost of brokerage commissions alone. (Investing in mutual funds and index funds is "passive investing" because the investor doesn't have to pick stocks herself.) Also, forget about the tax ramifications of trading stocks too frequently - they can eat up all of your profit if you don't know what your'e doing. All of this information might not serve you well though because it fails to take into account why we invest: TO MAKE MONEY. More specifically, we invest to make sure that we beat inflation (that our savings don't go down in value).

The conventional wisdom talking heads like to tout the fact that the S&P 500 index has returned 9.8% per year, ever since 1928. Really? Great! Where do I sign up to get 9.8% per year returns for the next 87 years? If you can't sense my sarcasm, let me point out the problem with this statistic for you. This chart shows the returns of the S&P 500 index starting in 1975. For argument's sake, let's go back to the year 2003 and start from there when calculating returns.

Using the chart I reference above, if we invested $1,000.00 in an S&P 500 index fund starting in 2003, we would have had $1,260.00 at the end of 2003, $1,373.40 at the end of 2004, $1,414.60 at the end of 2005, $1,608.40 at the end of 2006, $1,665.17 at the end of 2007, at the end of 2008...we would have essentially returned to our starting amount, ending the year at $1,024.08. As you already know, in 2008, the S&P 500 dropped a whopping 38%. Just imagine seeing all of the money you've worked so hard to save and invest slashed by 38%. It'd be heart wrenching to say the least, even for the most seasoned investor. If you'd started investing in 2000, you'd have lost money from 2000 to 2008!

Yes, the major stock market indices generate a return of somewhere in between 7 to 9% a year over very long periods of time. However, over short periods of time, the returns from the stock market can wildly deviate from the historical averages. And since most investors don't have 87 year time frames to invest their money, oftentimes, they are unable to capture the true benefits of investing in the stock market.

If you're an investor who is solely investing for retirement, and have a 35 to 40 year time horizon, fine, be my guest and go ahead and invest in an index fund. But if you're like me, and you invest so that you can afford to live on your own terms, even before retirement, then you need to be actively engaged in your investment decisions. That's not to say you should become a day trader or a market timer. But the index fund investment route is not the way to proceed.

If you want to know what you should do instead of investing in index funds, tune in tomorrow! Until then, take care and I'll see you back here soon.

JP $