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Index Investing Makes Sense

2011 May 27

From time to time, I’m asked for advice on how to get started in investing, or how to respond to a bad investing experience. Putting aside mistaken ideas about investing is a very good first step. You can get 80% of the results for 20% of the effort if you keep it simple.



These suggestions do not replace in-depth self-education or objective, knowledgeable professional advice, but they should prove helpful as a good place to start.

  Common Mistakes Things You Should Know Pretty Good Answers
1. Mistake price inflation for real investment returns. Real returns are provided by economic growth. Price changes and taxes just affect who owns it. Remember to subtract inflation and taxes from your returns. Think about whether the average investor can earn more than economic growth.
2. Think that it is easy to earn above-average returns. If you want more, someone just as intelligent as you must give up the difference. Invest in stock index funds or ETF’s.  Add enough bonds and cash to fit your risk tolerance .
3. Buy stocks of only well-managed growth companies. The stock is not the company.  You need more diversification. Buy broadly diversified stock index funds or ETF’s, or hold
many different kinds of stocks.
4. Pay high fees for active management based on past performance. Competition converts predictable economic events into nearly unpredictable stock price movements. Allocate assets to stocks assuming you cannot time markets or pick managers.
5. Make decisions on isolated individual securities without thinking about diversification.  Hold more than 10% of your portfolio in the stock of your employer. The relationships among returns across different elements of your portfolio determine much of what you will experience. Diversify holdings between stocks and bonds, and within stocks, among various industries, across big and small, growth and value, US and international.
6. Think fees, trading costs, and taxes are unimportant.  An extra 1% in fees, trading costs or taxes can dramatically affect compounding of wealth over a long period.  Keep turnover low and keep fees low. 
7. Avoid the stock market entirely. People will pay you to bear risk that is hard to diversify or hedge. Otherwise, your long-term real return is likely to be less than economic growth. Keep a risk-appropriate fraction of your wealth invested in a broadly diversified stock portfolio.
8. React with emotion when the stock market rises or falls a lot. Expected return for the market has only a small relationship with past performance.  Make modest adjustments in stock-bond proportions as your
financial circumstance, not the apparent return of the market, changes.
9. Spend lots of time reading the financial press, financial TV, and Internet news sites. Risk, tax and fee knowledge retains its value even if widely shared.  Ideas for extra return do not. Forget picking stocks or timing the market.
10. Rely on advisors who can do well only by getting you to churn your portfolio. Pay high fees for unproductive management. Most financial service companies are structured in ways that  produce conflicts of interest. Consider fee-only financial planners, brokers who want lifetime relationships, or money managers with low costs who emphasize risk management and reduction of any tax impact.