Last year, the market endured its worst performance since 2008, yet companies like Exxon, Merck, and Northrop Grumman all posted returns in excess of 40 percent. How does this happen, and more importantly, how do investors find these winners and avoid negative returns?
While I can explain how it happens, if I knew how to simply just discover the winners, I would day trade in my pajamas and wouldn’t work for anybody else. Unfortunately, there is no magic formula to simply choose the best performers. And that brings us full circle to index funds.
When you read or hear that “the market” is down this year, what exactly does that mean? Typically, it means that the S&P 500 is down. The S&P 500 is an index that measures the performance of the 500 largest American companies and represents roughly 80 percent of the dollars invested in the U.S. stock market.
An index fund, then, is an investment fund that is attempting to mimic the performance of a particular index. If the index in question is the S&P 500, then the fund will have exposure to all 500 of those companies. While that includes Exxon, Merck, and Northrop Grumman, it also includes all of those stocks that lost value.
So why then invest in index funds? Wouldn’t it be better to just concentrate on the healthy companies and leave the others out of the portfolio? And, of course, it would, but since nobody knows which companies will succeed and which will fail, the safest and most cost-effective approach is to invest in all of them through an index fund.
Index funds are passively managed, meaning that there is no human making decisions about which investments are included. It simply tracks the formula. Conversely, actively managed funds feature human managers that sort through the fundamentals of each potential stock, trying to find the best ones. However, those humans rarely outperform the formula with any consistency.
The one thing that is consistent with an actively managed fund is the cost. Humans get paid, formulas do not. And that makes the costs on index funds substantially lower than their actively-managed counterparts.
Furthermore, the index funds have performed well over time. They also allow investors to avoid the risk that comes with a single stock. Yes, risk produces return, and if the returns were always like the companies listed above, there would be no merit in index funds. But at one point in time, companies like Blockbuster Video, Enron, and Radio Shack enjoyed outlandish returns. However, had you held their stocks when they went bankrupt, you would have lost the entirety of your investment.
Index funds really turn out to be more of a measure of the overall health of the economy rather than the health of an individual business. The fund is unlikely to produce returns of the magnitude of Exxon last year, a whopping 80 percent. And that makes them boring. But they are consistent and safe over long periods of time, and that makes them successful.
The strategy at Force Acres is to remain boring with your core investments. I want our investment portfolios to be consistent, safe, and cost-effective, and therefore I rely heavily on index funds across multiple asset classes.
Once your core investments reach a point that enables you to achieve your financial goals, then it could be a good time to begin exploring some more excitement outside of your core. But until then, I remain an advocate for the steady and boring route to financial independence.