If we look at things very simply, there are 3 main options, how to invest in stock market:
1. Select stocks yourself
You can create a stock portfolio of companies that you believe in and hope that these companies will grow and make you rich. But to get good results over the long-term, you will also need to spend lot of time learning about stock market. If you don’t have time and will pick stocks without doing any research, you risk getting burned.
For example – this is how GoPro stock chart looked like after IPO – price shot up 300% from $30 to $90 in just 3 months. Imagine, how high it could go in 2 years? Let’s say, you would have invested $990 and bought 11 GoPro shares in Oct 2014, paying $90 for each share.
Fast forward to Mar, 2016 – price per share is $11.7 and you have lost 87% of value. If you would sell your GoPro shares, you would get back $128.70. On top of that you would have to pay commissions for each trade, and in the end your investment of $990 would turn into ~$100.
Not exactly, what you were looking for? Gambling in a casino and loosing 90% of your money would produce the same return, but at least you would get free drinks and have some fun.
Of course, you could also select good companies, but even then you risk doing poor decisions based on emotions, and still loose money:
2. Let others manage your money
Another option is to give your money to professional fund managers, who have good education, experience and should have better performance. Right? Well, actively managed funds should perform better when compared to a retail investor, who invests in GoPro.
But if you compare actively managed funds to their benchmarks – low cost index funds with no managers, then in almost all cases actively managed funds perform worse:
While it may be counter-intuitive, academic research has shown that because of a) the inherent difficulty of consistently picking stocks that outperform the market averages and b) the extra costs incurred by these funds for things like research, brokerage fees, and manager salaries, only the most skillful stock pickers actually end up beating the benchmarks over long periods of time. Plus, determining who those managers are in advance is a fool’s game.
Another interesting fact:
Nobel laureate Eugene Fama and Kenneth French wrote a comprehensive paper on this subject which found only about 2% of the 3,156 fund managers they examined had statistically significant evidence of skill. They also concluded that a portfolio of low-cost index funds is likely to perform about as well as a portfolio of the top 3% of actively managed funds (and better than the other 97%).
If you don’t want to pick stocks yourself, but still like gambling and think that you can pick the best fund manager from 50 others, then go for it – you will pay big fees for a 2% chance of outperforming the market.
But remember – that even the biggest hedge funds lead by smartest managers fail once in a while. One good example is a health care company Valeant Pharmaceuticals International Inc. ($VRX), which was owned by more than 100 hedge funds just less than a year ago:
Guess what happened next? In July 2015 price of $VRX reached $263.81, but because of many investigations & possible fraud the price has crashed 90% to $26.72 in less than 9 months:
It is interesting that one guy @AZ_value wrote a private blog and did a good job questioning the business model and financial reports of this company already in Aug 2015.
On the other hand – 100 hedge funds, who blindly followed one another and invested billions of dollars into a company without doing proper research, remind me of retail investors and GoPro. Would I want them to manage my money? Probably not.
3. Invest in whole market
If you are a bit skeptical about your skills to pick winning stocks or the greatest fund managers, but still want to get the best returns with least risk possible, then you should consider investing in a broad market index fund.
What is an index fund?
Thousands upon thousands of individual stocks are traded in the United States and around the world. A number of so-called indexes have been set up to track how a particular part of the stock market – or the stock market as a whole – is doing. There are indexes that track large-cap companies, small-cap companies, the entire stock market and so on. One of the most common indexes is the Standard & Poor’s 500, known as the S&P 500, which represents a broad cross section of 500 large American companies.
What an index fund does is simple: It invests in the entire index. For example, an S&P 500 index fund buys all the stocks in the S&P 500 index. And that’s it.
What are the advantages of investing in an index fund?
- Low costs: index funds are passive funds – with no managers and no sales people, and very low fees – starting from 0.03% per year.
- Low risk: you invest automatically in many companies, and get the average returns of all of them grouped together.
- Best performance: over the long-term you will beat most actively managed funds
- Easy to invest: no need for complicated strategies or spending time on reading news and doing research. Invest & forget.
Some examples of indexes:
Standard & Poor’s 500 Index
The S&P 500 is one of the most commonly used benchmarks for the overall U.S. stock market. The S&P 500 measures the value of stocks of the 500 largest corporations by market capitalization listed on the New York Stock Exchange or Nasdaq Composite.
Dow Jones Industrial Average
DJIA is one of the oldest, most well-known and most frequently used indexes in the world. It includes the stocks of 30 of the largest and most influential companies in United States.
The Wilshire 5000
The Wilshire 5000 is sometimes called the “total stock market index” or “total market index” because almost all publicly-traded companies with headquarters in the U.S. that have readily available price data are included in the Wilshire 5000.
What would Warren Buffett do?
As an investor, you should be skeptical of any advice and extra careful when reading private blogs, so don’t trust me, but consider the advice of one of the greatest investors in the world – Warren Buffett. His record speaks for itself:
Berkshire Hathaway’s stock price increased by a mind-blowing 1,800,000% between 1964 and 2014. The S&P 500, on the other hand, increased by “only” about 2,300% over that time.
So what is the advice of one of the richest people in the world? Let me quote a part of Warren Buffett’s 2013 annual shareholder letter:
Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.
I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.
What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
So if one of the best investors in the world has asked in his will – to put 90% of his cash in a low-cost S&P 500 index fund – maybe it is not a bad idea to do the same with your investment?
How to invest in indexes?
You can invest in any index by buying shares of an equity traded fund (ETF) that tracks the corresponding index. You can buy and sell any of these ETFs just like you would trade a stock for an individual company. The only difference – when buying a share of an ETF – you become a shareholder not of 1 company, but all the companies that are tracked by the index. Some examples below:
|$ITOT||0.03%||S&P Total Market Index|
|$VTI||0.05%||CRSP US Total Market Index|
Where can I learn more about this?
I highly recommend watching documentary: “How to Win the Loser’s Game”
And also listen to a recent interview with Jack Bogle, who created the first index fund available to individual investors and founded The Vanguard Group, that manages approximately $3.0 trillion in assets: