The Best Investing Strategy: Low-Cost Diversification

Every so often a new “can’t-miss” investing strategy becomes popular.  Dogs of the Dow, buy on the dips, only buy stocks trending above their 90 day moving averages, sell covered calls,  buy small cap stocks in December and sell in January, etc are all examples of mechanical investing strategies originally touted as bringing superior long-term returns with little or no risk.  These strategies were usually backed up by extensive back-testing to “prove” the strategy works.  But just because something worked in the past doesn’t mean it will work in the future.

An Investing Strategy That Actually Works

A low-cost diversified portfolio, on the other hand, will never finish near the top of the performance charts.  It will never be the investing strategy of choice for the talking heads on the television financial shows.  It will never be exciting and will never get you attention at cocktail parties.  What it will get you, however, are consistently above-average returns.

Even if those strategies had merit when they were publicized (most didn’t), the very act of publicizing them causes them to stop working.  If everybody knows small-caps rise in January, they will start buying in December to take advantage of the fact, which ironically will cause them to rise in December instead of January, prompting still others to buy in November in anticipation of the December-buying-to-take-advantage-of-the-January effect.  An investing strategy everybody knows about is an investing strategy that no longer works.

Low-cost diversification is a bit of an anomaly.  It doesn’t promise large profits (or any profits at all), but it does seek to maximize whatever profits there are to be had (or minimize whatever losses) by capturing the returns of the capital markets as closely as possible.  By definition, the investment returns earned by investors is equal to the return of the overall market minus investment costs.   This gives low-cost  index funds an inherent advantage over their more expensive actively-managed competitors.  It’s no surprise index funds tend to beat actively-managed mutual funds by about the same as the differences in their expense ratios (which is why costs matter so much).

When it comes down to it, which investing strategy would you rather rely on:  some half-baked theory cooked up a journalist somewhere or a time-honored strategy followed successfully by thousands of investors with the odds heavily in its favor?  Me, I’ll bet with the odds.