When You Invest For Growth In Stocks – Diversify and Keep Your Costs Low.

Rebuild Your Wealth on Solid Ground. (Part 3 of 4):

Can you find the next hot technology stock before other people do? Are you sure? Or better yet, can a stockbroker working at a big bank or brokerage find it for you, and then tell you to buy it before all the hedge funds and money managers and the rest of the world does? You should know the answer to that.

Let’s step back for a minute. What's the real reason that you invest in stocks? To lose sleep? To help replenish the profits of the bailed-out banks and brokerages by paying lots of hefty commissions when they sell you mutual funds and stocks? Of course not. Your purpose for owning stocks is to build wealth over a long period of time by the compounding of your returns, and to offset the wealth-destroying effect of inflation.

So why does it seem so hard to invest in stocks and achieve long term success? Do stockbrokers have some mysterious inside knowledge of which stocks to buy (and when to sell them) that they only share with their best customers? They’d like you to think that, but no, they don’t. Neither do the experts on TV. (Even if they occasionally did, after they announced their picks on TV, everyone who was going to use that information would already have acted on it.) The truth is, there's a lot of research that demonstrates that very few professional money managers (including managers of mutual funds) can consistently beat the stock market. They do in some years, and then fail to in other years. If those full time professionals can’t, how can your stockbroker, the cable TV screamers, your best friend, or even you—do it consistently?

The better way, in my opinion, is that you should quit trying to beat the stock market and join it. Over very long periods of time, the stock market itself (all stocks combined) has given good returns. Of course, over the last ten years, that hasn’t been the case. 2000 – 2009 has been called the “lost decade” because the stock market actually ended lower than it started, and the decade ended with a deep recession. But previous decades with very low or slightly negative returns for stocks, even when accompanied by a rough economy (such as the 1930s), have been followed by better times for both (stocks and the economy) in the next decade ^[1]. I think that’s likely to happen again in the next few years, although, of course, there's no guarantee.

What does it mean to “join the market” when you invest? It means to diversify your investments in stocks so well that your portfolio holdings are very close to the stocks that make up the whole market. One of the most efficient ways to achieve good diversification is to use index funds—which you can invest in as ETFs or traditional mutual funds. For example, the most widely known index funds are those that invest in the S&P 500. These funds own the stocks of 500 of the largest companies in America. Other index funds invest in mid cap and small cap stocks, as well as in other groups of large cap stocks in the U.S. By investing in a group of broad-based index funds (meaning those that don’t concentrate on certain industries), the returns of the U.S. portion of your portfolio can be very close to that of the stock market itself. You should also have a part of your portfolio invested internationally, and you can achieve great diversification there with index funds.

Index mutual funds also help keep your costs low, compared to actively managed mutual funds. “On the whole, expense ratios [ongoing annual fees charged by the fund] range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund [in U.S. stocks] charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds...” ^[2] Since the SEC says that "Higher expense funds do not, on average, perform better than lower expense funds,” ^[3] there is rarely a good reason to buy higher expense mutual funds.

Another expense you can avoid with index mutual funds is the commission, or “load” that you pay brokers and agents to buy mutual funds. If you pay a broker a front end commission of up to 5% to buy a mutual fund, you often also pay annual 12b-1 fees of 0.25%. If the broker or agent sells you a fund with a “contingent deferred sales charge” instead of a front end commission, your annual 12b-1 expenses and shareholder service fees can add up to as much as 1%. In this case, your annual bill (embedded in your mutual fund) can be 2% or even higher. Ouch. Much better to invest in index mutual funds with no broker “load”, redemption fee, or 12b-1 charges, and a very low management fee.

Buying ETF index funds is a little different. ETFs have very low expense ratios, but you buy and sell them just like stocks. So, you have to pay a commission each time to a broker unless you are buying them in a fee-based account where commissions are waived. Many stockbrokers and insurance agents have caught on to the popularity of ETFs, and are using them as trading vehicles to generate commissions from their clients—just like they used to do with individual stocks. This can be bad for two reasons: short term trading isn’t investing, and when a broker receives a commission every time you buy or sell, he has a big incentive to get you to trade—which is a distinct conflict of interest.

Keeping your total investment costs low is very important to your long term success as an investor. To control your costs, understand what they are, and think about whether you benefit from the incentives they create for the person you’ve hired to help you.

^[1] Tom Lauricella, “Investors Hope the ‘10s beat the ‘00s,” WSJ, 12-21-2009, p. C1.
^[2] Quote [with information in brackets added by me] is from Investopedia at http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp See also: William J. Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between (New York: John Wiley & Sons, 2010), p.140. The SEC web site that explains types of mutual fund fees is http://www.sec.gov/answers/mffees.htm#distribution
^[3] Investopedia, http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp