Have you ever looked at the list of investment options and thought to yourself “where on Earth should I start?” Getting started is easily one of the largest barriers to investing. Once you’ve made your first investment it becomes significantly easier to learn more. The key is to start with a small initial investment that will get the snowball of personal wealth rolling.
Which Stock Should I Pick?
While its true there’s a wealth of knowledge required to become a successful investor, there are simple ways to get your best bang for buck. A majority of us (myself included) don’t have the time or desire to do laborious, detailed, industry specific research. Our goal is to get from 0 to 80% with a sound investment plan. We want the other 20% to consist of fine grained details we can sweat later. For our purposes, it’s good to begin by purchasing shares of Vanguard’s Total Stock Market Index (VTSMX).
Below is a list of the top 15 holdings that make up our chosen fund. Notice any familiar names? Source: Morningstar
By purchasing a single share of VTSMX we are essentially buying a tiny slice of largest companies in America, as well as slices of mid to small companies. An example of a similar fund is the Vanguard 500 Index Mutual Fund VFINX. As you can guess, this index fund tracks the top 500 companies in America. By purchasing a share of VFINX we essentially own a piece of America’s largest 500 companies.
Index Funds vs Managed Funds
Let’s take a step back and take a look at the name of our fund: Vanguard Total Stock Market Index Fund (VTSMX). We can figure out that “Total Stock Market” means the fund tracks the entire U.S. stock market, but what does the index mean? An index fund is passively managed, meaning their portfolios have rules to track a certain group of investments and can run fairly autonomously. On the opposite spectrum are managed funds. Managed funds are actively managed by individuals which aim to outperform a certain investment benchmark.
Index funds consistently outperform any active fund for three main reasons:
- They have lower management fees
- They have a lower turnover ratio (less buying and selling of securities means less taxes)
- They aren’t prone to human error
On the topic of human error, there are plenty of poor portfolio managers out there. Experts can check portfolio manager histories before purchasing any their shares, but even then it’s possible a funding manager can switch over to another portfolio to leave them in the dust. Well managed active funds do exist. Funds with performance above their benchmarks and peers can make excellent investment vehicles, but index funds are able to consistently deliver long-term returns.
Paying Less Is Earning More
John C. Bogle is a famous investor best known for his low cost portfolios that paid off in longer time horizons. He’s been labeled as one of the “Four Giants of the 20th Century” among the investment community, and ranks among Warren Buffet, Peter Lynch, and George Soros. His investment strategy can be summarized as:
You get exactly what you don’t pay for.
He drives home how important it is to have low management fees with consistent performance over time. Manged funds have trouble consistently beating index funds over longer time horizons, because of the compounding cost of their higher management fees. Below is a graph that draws out a Vanguard Fund with a yearly fee of 0.07% compared to a fund that runs for 1.32%. The difference between their management fees is a 1.25%, which doesn’t seem like such a big deal right?
Woah there. It turns out a whopping 27% of your potential retirement savings is lost when estimated over a 40 year period. Higher management fees bring a double whammy of shelling out cash to managers, and with it the potential earnings of your hard earned cash. To add the cherry on top, we already know that actively managed accounts have trouble beating index funds in the first place. That’s even before accounting for all the management fees!
While it’s possible to get excellent returns from investing in particular stocks or portfolios, a majority of people simply don’t have the time to do that level of homework. Most of us don’t need to look deep into portfolios to actively maintain it. By skipping exorbitantly high fees we can ensure simplicity while also achieving the best bang for buck. Keep an eye out for lower portfolios when investing in your 401(k) or Roth 401(k). If your employer doesn’t offer any matches, consider opening an IRA instead.
Once you’ve gotten the ball rolling towards a stable financial future, take another step. We’ve already started diversifying our portfolios with a good index fund choice, but we can also learn more about the importance of diversifying your portfolio here.
Per usual, thanks for taking the time to read BrunchBucks. If you find a typo just contact me via email! Feel free to leave a comment below or share this with friends.
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