Thursday, December 17, 2009

The Smart Way to Invest... Index Funds...


The book I read this week was The Smartest Investment Book You'll Ever Read by Daniel R. Solin. I loved it. Fantastic ideas that follow my personal investing philosophies.

Solin's book has four sections although I feel like there were really two main ideas. One, that index funds are a more solid investment strategy than stocks or mutual funds because you cannot, nor any "professionals," beat the market. And Two, how to invest in the index funds (the fun part.) Solin provides solid research that shows results of many studys. All evidence points towards using index funds. "Financial Experts" and Wall Street have spent lots and lots of money on marketing themselves. They pitch themselves as having a financial expertise that helps them predict the market. This is false. Marketing dollars have also gone into telling the public that mutual funds will provide a great return because of the diversity and that they are being maintained by a "financial expert" that can beat the market with their expertise. This is also false.

The Truth: You can make just as much or more money than any "financial expert" and you can do this by avoiding mutual funds and investing in index funds.

There are just a couple differences between index funds and mutual funds, but the differences make a huge difference. A mutual fund is managed by a person, this person is supposed to be able to predict what stocks and bonds will rise and fall, so they buy and sell to appropriately position the fund to make high returns... you pay a premium expense to have this "luxury." An index fund is managed by a computer and the computer buys and sells stocks to position the fund in line with the right ratio of the market. This means the index fund will always earn the market average. Now for the great news and another difference.... Mutual funds earn less than the market average 95% of the time. So you have a 5% chance to have a mutual fund that does better than a index fund. Additionally, many mutual funds have an expense ratio of about 1.4% whereas an index fund has an average expense ratio of .3%. So if that mutual fund does beat the market by a whole percent, which is very unlikely to begin with (5%), you would make more money if you had invested in the index fund. Why would you pay a premium to lose money? Great question... You shouldn't.

The book also analyzes the differences between the Smart Investor and the Hyperactive Investor. The Hyperactive investor is the "financial expert"- They spend all day every day trying to beat the market. This is very unlikely, very few individuals have been able to beat the market for an extended period of time. One of these people is Warren Buffet and it is unlikely that he is your financial adviser. The Smart Investor understands that you can not beat the market and also understands that in the long-term, the market makes great returns (9-12%). So this Smart Investor puts his money into index fund which pay the market average. Being a Hyperactive Investor is a great way to spend a lot of time getting no where... I am not a fan.

Can you do it yourself? Yes!

I am confident saying that anyone investing less than one million dollars can do so themselves, with very little oversight (checking in every 6 months or so). Now onto the what, how, and where... I am going to spell it out for you so read carefully. There is a rule of thumb for the ratio someone should use when they are going to be investing. Take your age and subtract it from 100 and that is what you invest in stocks vs. bonds. So if you are 30 years old you will invest 70% in stocks and 30% in bonds. I will use a 30 year old for the example below and we will use what Solin considers the Medium to High risk investor.

Here is your how-to... Write it down if you have to...

First go to either Fidelity or Vanguard and create an account (www.Fidelity.com or www.Vanguard.com) Both companies handle taxable or tax-favored accounts (IRAs and Roths) and both offer funds that have as low as a $3,000 minimum investment. Once you have your account use your ratio and purchase accordingly into these funds

30 year old =

Fidelity-
52% FSTMX <---(This is the fund that you will purchase)- This is a domestic stock fund
18% FSIIX- This is a international stock fund
30% FBIDX- This is a bond fund

Vanguard-
52% VTSMX- This is a domestic stock fund
18% VGTSX- This is a international stock fund
30% VBMFX- This is a bond fund

The book also goes into investing in ETFs (Exchange Trade Funds) but I don't like ETFs. People invest in these if they want to own a portion in a commodity. If you are going to buy into a commodity, buy into gold and silver, hedging inflation, and don't buy the ETF. Buy the real thing off www.apmex.com.

Well I just gave you a very powerful road map to great fortunes... I highly recommend this book. It's a very easy read and has great advice.

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