What Matters In Investing
The financial media has a vested interest in making investing appear more complicated than it really is (this blog included, I suppose). The thing is, investing isn’t complicated. If you can add 2 + 2 and are literate, you can invest your own money effectively. The Oblivious Investor (check him out if you haven’t already) got it right on his About page when he says “the majority of what the media tells us about investing is–for the most part–irrelevant” and “investment success is based upon stubbornly following a few (very simple) principles.”
You don’t need to be a financial wiz, be able to analyze the details of an obscure firm’s financial statements, or understand the difference between alpha and beta to invest you portfolio every bit as well as the pros. After all, at the end of the day most pros can’t beat the market either. You can do at least that well with index funds.
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What Really Matters In Investing?
There are really only two things you need to worry about when it comes to investing: diversification and expenses. You can read my post on portfolio theory for more on the basics of diversification and why it’s a good idea, but for now simply take my word for it. As for expenses, lower is better.
The Least You Need To Be Diversified
It’s easy to go over-board diversifying your portfolio (just check out my retirement portfolio), but there are really only three asset classes you absolutely must have.
- Large-cap U.S. Stocks
- Large-cap Foreign Stocks
- Intermediate Term U.S. Bond Fund
Real estate, small-cap stocks, commodities, and other esoteric asset classes may very well have a place in your portfolio, but aren’t absolutely necessary. Owning just these three asset classes in equal proportions will put you ahead of the vast majority of professional portfolio managers.
Expenses Are The #1 Determinant Of Long-Term Returns
Tons of research has shown that expenses are the most accurate predictor of a fund’s (or portfolio’s) long-term performance. The reason is simple: the average return of all mutual funds is simply the stock market’s return minus the average expense ratio. Over the long term, statistically you cannot expect to out-perform the broad market. You can out-perform the vast majority of other investors, however, by keeping your expenses razor-thin. The best way to do this is by using index funds; however, there are many quality actively-managed mutual funds out there with expense ratios below 0.75% (the maximum I would recommend). You can get expense ratio information from Morningstar (I suggest registering for their free account
, which gives you access to all their various portfolio tools, stock screeners, and calculators in addition to mutual fund information). The lower your portfolio’s combined expense ratio, the higher your future returns are likely to be. It’s very possible to construct a well-diversified portfolio for less than 0.20% per year.
That’s All You Need To Know
That’s it, that’s all you need to know. Investing in low-cost index funds over the above three asset classes is all you need to do to invest your retirement savings every bit as well as most pros. It really is that simple. Of course, older or more risk-adverse investors may choose a higher bond allocation while younger, more risk-inclined investors may choose to go a bit heavier on the stock side, but for the most part very few decisions need to be made.
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Hi Kyle. Thank you for the mention.
And thank you for being willing to “tell it like it is,” so to speak. I suspect that many bloggers are afraid to take a stand out of a desire to avoid any sort of liability.
For example, instead of keeping it simple and saying “The lower your portfolio’s combined expense ratio, the higher your future returns are likely to be” they’ll qualify the statement in so many ways that it’s no longer saying anything at all.
I suspect this will be your last blog post since you let the cat out of the bag?
Just kidding. Nice article. I’m off to sign up for that free account and test my expense ratio. Thanks for the tip!
Good summary, but where are the ETFs instead of mutual funds? If you can make a good lump-sum payment into an ETF it’s going to be cheaper than funds. Also, considering that commodities are the basis of real production I don’t think I would call them or even real estate esoteric – they’re pretty fundamental, at least they are for me. I can appreciate the idea of the “least diversification you need,” in terms of keeping it simple, but the downside to that of course if it you’re all in indexes then when a September 2008 happens, your whole portfolio goes down. It does require much more work to pick individual stocks, but I liked seeing that some of my consumer and health care stocks barely got scratched during the downturn.
You have done a good job by showing us the easiest and simple way to invest. Yeah, I have to admit that I really confuse and think that investing is very complicated. But after reading your post, I understand that investing can be simple too. As long as we know what we want and invest accordingly, I think things will be better.