This is so simple but so important. Trying to out-guess the stock market experts is for suckers. I learned early in my career that even with loads of internal information that you still can’t predict what the market will do. I never traded on it, of course, but there times when Compaq would release record earnings but the stock would go down because of some comments about future performance.
Just invest in broad index funds (mutual funds that mimic the overall market). There is no need to chase stock tips or highly managed mutual funds. The only exception would be if your employer sold you stock at a discount, which would mitigate the risk. Just don’t be foolish like a lot of Enron employees were and put most or all of your retirement money in one company. I knew way too many people at Compaq and HP who tried to time peaks and missed out.
As noted below, keep in mind the simple math: Index funds with minimal fees will yield 7%. Managed funds will be more like 5%. So you are 2 points behind, right? No, it is much worse. If inflation is 3%, then your net gain with index funds is 4%. That’s double what you’d get with managed funds.
Charles Rotblut CR: Since you founded Vanguard, would you explain why you think investors should use index funds?
John Bogle JB: Let’s start off with the obvious. Imagine a circle representing 100% of the U.S. stock market, with each stock in there by its market weight. Then take out 30% of that circle. Those stocks are owned by people who index directly through index funds. The remaining 70% are owned by people who index collectively. By definition, they own the exact same portfolio as the indexers do in aggregate, so they will capture the same gross return as the direct indexers. But by trading back and forth, trying to beat one another, they will inevitably lose by the amount of their transaction costs, the amount of the advisory fees they pay, and the amount of all those mutual fund management costs they incur: marketing costs, processing, technology investments, everything. When we look at the big picture of the costs of investing, including sales loads as well as expense ratios and cash drag, it is a foregone conclusion that active investors, in aggregate, will underperform index investors. It’s the mathematics.Borrowing a phrase from Louis Brandeis: It’s the relentless rules of humble arithmetic. The 30% of investors who own index funds capture almost all of the market’s return. In a 7% return market, indexing should deliver approximately 6.95% to investors. A typical Vanguard all-market index fund charges 0.05%. The remainder—those who are trading back and forth, hiring managers, and all that kind of thing—will incur costs, in round numbers, of about 2% per year. So, the indexers are going to capture pretty close to a 7% return in a 7% market, while the active investors, who also collectively own the index, are getting the same 7% gross return minus about 2% for all those fees and costs, a net return of 5%. It is definitional tautology that the indexers win and the traders lose.
I highly recommend Vanguard for their mutual funds. They are very easy to do business with and have extremely low fees.