Archives for February 2011

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How Much Work Is Do-It-Yourself Investing?

I was recently asked how much time it takes to be a do-it-yourself investor (as opposed to using a financial advisor to manage your portfolio for you).

My reply was that it takes a considerable amount of time, which is interesting because the actual management of a do-it-yourself portfolio hardly takes any work at all:

  • Rebalancing once per year is usually enough,
  • Contributions (or withdrawals) can be set up to happen automatically, and
  • Tax loss harvesting aside, there’s little benefit to checking your portfolio very frequently.

In other words, managing a do-it-yourself passive portfolio consists mostly of patiently, willfully doing nothing. (I’ve always liked the term “benign neglect” that John Bogle uses in his Common Sense on Mutual Funds.)

So Why Does It Take Work?

It takes work because in order to be successful over the long haul, you’ll have to educate yourself. You have to educate yourself so that you’re prepared for two challenges that will arise.

Challenge 1: At some point in time, your portfolio will perform downright miserably. (Exactly how miserably depends on whether you have an aggressive or conservative asset allocation.)

You need to be prepared for that. You need to know why you chose your portfolio in the first place, and you need to know why a period of lousy performance doesn’t necessarily mean you chose poorly.

Challenge 2: Over the course of your investing career, there will be many times when somebody (whether a broker, a financial advisor, your neighbor, an insurance agent, an author, or somebody on TV) comes along recommending a different investment strategy. And that person will have data showing that over some particular period(s), his/her strategy performed better than your own portfolio.

You need to be prepared for that too. You need to be able to spot the flaws in their arguments so that you don’t give in and swap out your entire portfolio every time someone comes along with a different suggestion.

Education is Inoculation

Educating yourself about investing works to inoculate you against both the doubts caused by periods of poor performance and the numerous alternative-strategy sales pitches you’re sure to run into over the years. The more you know, the safer you are.

Advantages of Investing in Index Funds

While I certainly don’t think that all actively-managed funds are poor investments, I am firmly convinced that most investors would be better off using index funds instead.

Why? Because of costs.

It’s simple math, really.

Let’s imagine that over the next decade, all the publicly owned companies in the world economy earn a grand total of $800 trillion. As a result, the most that all of the shareholders of those companies could earn on their (stock) investments over the decade would be $800 trillion. Simple so far, right?

However, in reality, the total amount earned by the whole group of investors would be significantly less than $800 trillion. Why? Because of investment costs–things like brokerage fees and commissions, mutual fund sales loads, mutual fund operating expenses, and so on.

In fact, the total amount earned by investors will be precisely equal to the total amount earned by all the public companies, minus the grand total of the investment costs incurred. Or, to put it mathematically:

Total Return for Stock Investors = Total Stock Market Return – Total Cost of Investing

The less investors pay (in total) in investment costs, the greater total return we will earn. Or to be blunt: Investors would make more money (in total) if actively-managed funds didn’t exist.

How this affects you

Of course, the real question is whether you will make more money by paying a fund manager to select investments for you as opposed to using an index fund that simply holds every stock in the index. And the answer, of course, is “you might.”

…but it’s unlikely.

Why? For precisely the same reason, actually: investment costs. Let’s say that over the next decade, the stock market earns a 10% rate of return, and investors on average pay investment costs equal to 1.5% of assets. In this scenario, the average dollar invested will earn a return of 8.5% (10% – 1.5%).

The average dollar invested in an index fund, however, would earn very close to what the market itself actually earned: 10%. (In reality, it would be closer to 9.8% after accounting for a typical index fund expense ratio of 0.2% of assets.)

In other words, while some dollars invested in actively-managed funds will beat the market, most of them won’t.

An analogy

Try thinking of it this way: You have a hat in front of you. In it are scraps of paper with the numbers 1-99 written on them. You are given two options:

  • Pick a scrap of paper without looking, and you will win an amount of money equal to the number on the paper. Pull a 20, win $20. Pull an 87, win $87. Or…
  • Win $72 automatically.

Taking the $72 obviously puts you ahead for 76 out of 99 possible outcomes. Similarly, index funds are shown in study after study to outperform greater than 60% of their actively-managed peers. (The 72% number came from this article.)

What do you think? Want to pick a number?

How Often Do You Check Your Portfolio?

  • I check the mail everyday.
  • I check Google Reader twice per day.
  • My email is in a state of “constantly being checked.”
  • As a blogger and business owner, there are about 100 other things (revenue, traffic, incoming links, etc.) that I check fairly often.

And from what I gather, I’m fairly normal in this regard. For most people, if something is:

  1. Important to us,
  2. Easy to check, and
  3. Frequently changing/being updated,

…then we tend to check it frequently.

Account balances clearly fit all three requirements. There’s no way to argue that your IRA balance isn’t important. It’s no harder to check your 401(k) balance than it is to check your email. And your brokerage balance changes (sometimes dramatically) everyday.

And That Makes Investing Difficult.

Checking your portfolio everyday can get you into trouble. On a day-to-day basis, the fundamental returns (i.e., the earnings of the companies you own plus the interest on the bonds you own) are invisible. If we assume a fundamental nominal return of 6% per year and we assume 252 trading days per year, that works out to a daily return of just 0.024%. If you ask me, that’s basically invisible.

In an entire month, the fundamental return would be just half of one percent: still pretty close to invisible.

If you check your portfolio everyday or even every month, all you’re seeing is the noise. You can’t possibly notice the slight fundamental return that’s buried within a mountain of P/E-related effects. Yet, dividends and earnings growth are the primary drivers of long-term stock returns. They are what we should be paying the most attention to.

So How Often Should We Check?

Of course, you can’t completely ignore your portfolio. You have to check every once in a while to rebalance and to see if you’re on track to meet your goals.

As for me, I check 2-3 times per year. (One is scheduled; the others are because curiosity gets the better of me on occasion.) For my purposes, that’s plenty.

What about you? How often do you check your portfolio?

What’s In My Portfolio?

In the last couple weeks, I’ve had a few people ask me about my own portfolio. I was surprised to find that I’d never actually written about it before. So here goes:

  • Vanguard Total Stock Market Index
  • Vanguard Total International Stock Index
  • Vanguard REIT Index
  • Vanguard Intermediate-Term Treasury Fund

That’s it. Nothing fancy. Nothing even remotely clever. Just low-cost mutual funds in four different asset classes: U.S. stocks, international stocks, real estate, and Treasury bonds.

Why So Simple?

My primary reason for keeping things so simple (or perhaps my second reason, because plain-old laziness may be the first) is that it helps me avoid mistakes.

I have a tangible understanding of what each of those funds represents, and I have a firm grasp of what each of them is doing in my portfolio. The result: I’m never tempted to bail out of any of them at exactly the wrong time just because of poor recent performance.

Also important to me: My wife also understands the role of each of these funds. If I were to die, she’d be perfectly capable of handling the portfolio.

Tinkering or Chasing Performance?

In other words, part of the reason I keep things so simple is to avoid a pitfall I’ve seen many investors run into. They read an article (or book, or blog post) explaining the benefits of owning a particular type of investment, and they add that investment to their portfolio.

Then, when that investment has a period of poor performance (as all investments do from time to time), they start to have doubts. The argument behind owning that investment no longer seems quite so convincing. Or they may have even forgotten the argument completely–leading to a “what’s this one for again?” moment.

There are perfectly valid reasons to add other asset classes to your portfolio (a small-cap value fund or commodities, for instance), but if you don’t have a fundamental understanding of why you’re doing it, all you’re really doing is chasing performance. And that’s not likely to end well.

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