Personal Finance for Professionals Part II – Investing in Stocks & Bonds
Welcome back to Personal Finance for Professionals Part II, our multi-lesson series teaching you everything you ever wanted to know about investing in stocks and bonds. In Lesson Three, we discovered why investors buy stocks. In this lesson, we’ll discuss all the different ways you can invest in stocks, and which is best for the average investor (aka you!)
Understanding Stocks
Ways to Invest in Stocks
There are several ways to invest in stocks. You can buy stock in individual companies such as Microsoft, McDonald’s, General Motors, or GameStop. You can also purchase stock funds, which group the stock of multiple companies into a single security.
Individual Stocks
Investing in individual stocks is easy to understand. You buy shares of a company and hope the business is profitable and grows, producing either dividends and/or capital appreciation. Individual stocks trade freely when the markets are open. If you place an order to buy/sell a stock at 10 am, the transaction will occur in real time. On most trading platforms, you can even purchase fractional shares of individual stocks, which means you can buy a specified dollar amount instead of a specified number of shares.
While purchasing individual stocks is the most straightforward way to invest in the stock market, it’s also the riskiest. You can make a tremendous amount of money investing in individual stocks. An investor who bought $1,00 of Berkshire Hathaway stock in April 1990 would now have $302,008 36 years later. Thirty-six years just happens to be about the length of a physician’s investing timeline before traditional retirement. $1,000 invested in Amazon in April 2001 is now worth 86 times that amount twenty-five years later. Even more recently, an investment of $1,000 in Nvidia in April 2020 is now worth $29,498 in just 6 years! So, we should just invest all our money in individual stocks and get filthy rich, right? Unfortunately, it isn’t that easy to identify which companies will outperform, nor is it likely you will hold that investment through the ups and downs of 30-40 years.
For everyone who guessed right about Amazon, hundreds guessed wrong and lost all their money investing in a single stock. Even “safe” companies go bankrupt. Do these names sound familiar? Blockbuster, Toys “R” Us, Eastman Kodak, Lehman Brothers, Enron, General Electric? History is littered with once-powerful companies that faltered or failed due to mismanagement, technological change, foreign competition, or fraud.
Many more companies survived, but their stock prices remained flat for long periods of time. Even excellent companies can have this problem. Microsoft’s stock price was essentially flat from 2002 until 2013.
Diversification
Investing all your money in one company is putting all your eggs in one basket. If that company goes bankrupt, you lose everything. To reduce risk, investors must diversify by investing in multiple companies. If you own two stocks, one may go up while the other goes down. It’s also less likely that they both will go bankrupt at the same time. However, companies in the same market segment tend to rise and fall together; thus, holding 5 technology stocks does not make your portfolio diversified. Research shows that it takes approximately 30-40 individual stocks across various market segments to achieve the maximum diversification with the least risk.
Unfortunately, buying and maintaining a 40-stock portfolio, or collection of assets, is difficult and time-consuming. Additionally, there are approximately 4,300 publicly traded companies in the U.S., so which ones do you choose? It is exceedingly difficult for anyone to consistently predict which stocks will go up and which won’t.
Stock Funds
Stock funds combine shares of multiple companies into a single security. These funds allow you to diversify your stock portfolio without having to choose a diversified group of companies yourself. These funds come in multiple varieties, such as mutual funds, ETFs, and hedge funds, and in two management strategies, active and passive.
Fund Type 1: Mutual Funds
A mutual fund is a collection of securities, and there are both stock and bond varieties. Stock funds typically hold between 30 and 200 stocks, depending on how concentrated they wish to be. Mutual funds have traditionally been actively managed, but there are now some passively managed index mutual funds.
Mutual funds are listed under a stock ticker and trade once per day after the market closes. If you place an order to buy/sell at 8 am, the transaction will occur at the market price at the end of the trading session, encouraging buy-and-hold investing, as shares cannot be traded at intraday prices. Mutual funds often have a minimum purchase amount of thousands of dollars and can only be bought/sold in whole shares.
Fund Type 2: Exchange Traded Funds
Like a mutual fund, an Exchange Traded Fund (ETF) holds a collection of securities, allowing diversification within a single financial instrument. There are also stock and bond versions of ETFs. What separates ETFs is their ease of use. ETFs often have lower fees than mutual funds and offer more liquidity.
ETFs trade like stocks. You can buy/sell an ETF anytime the market is open. If you place an order at 11 am, the transaction occurs at 11 am. No waiting until the end of the day. There are also no minimum purchases, and you can often buy fractional shares.
Management Strategy 1: Actively Managed Funds
Actively managed funds have a fund manager who picks a collection of individual stocks to buy and hold, which can be changed at the fund manager’s discretion. Fund managers charge fees, or expense ratios, for their services, which typically range from 0.5% to 2% of the portfolio’s total value annually. Most mutual funds are actively managed. Most ETFs are not, but the number of actively managed ETFs is growing every year.
In actively managed funds, managers are trying to beat the market average to justify their fees. If the U.S. stock market returns 8% in a year, why would you pay a manager 1% of your invested assets to return less than that? By buying actively managed funds, you are abdicating the stock picking process to a “professional.”
When it comes to active management, if you pick a “good” fund manager, you might beat the market. If you pick a “bad” one, you will underperform. Unfortunately, there are more actively managed mutual funds (7,200) in the U.S. than there are publicly traded stocks (4,300)! So, now, instead of trying to pick which stocks will go up more than average, you have even worse odds of trying to pick which funds will outperform.
Management Strategy 2: Passively Managed Funds, or Index Funds
Passively managed funds do not have a manager making buy/sell decisions; instead, they aim to keep costs low by “indexing” or using another passive strategy. For our purposes, we can think of all passively managed funds as index funds.
Index funds attempt to mirror an index, such as the S&P 500 or the NASDAQ, by purchasing all the stocks in its target. An S&P 500 Index fund will contain all the stocks in the same market-cap-weighted fashion as the S&P 500. If a stock drops out of the index, the index fund must sell it. If a new stock joins an index, the fund must buy it.
Index funds typically have extremely low fees (0.04% – 0.1% annually). They were created in the 1970’s to allow investors to easily and inexpensively buy the entire market, avoiding the high fees charged by active mutual fund managers.
Index funds are not trying to beat the market; instead, they aim to accurately match their underlying index. There are Total Stock Market Index Funds that track the Wilshire 5000, or every single publicly traded stock in the U.S., as well as Total World Funds!
There are index fund versions of both mutual funds and ETFs, often tracking the same index. For example, Vanguard’s total stock market index mutual fund is VTSAX, while its ETF version is VTI.
A Word of Caution
As you read these pages, you will find that I repeatedly advocate for index funds. However, you must note that I am referring to low-cost, broad-based funds as originally conceived, including those that track the S&P 500, the total U.S. stock market, or the total world market. Unfortunately, index funds now come in so many forms that they can be almost unrecognizable.
When I first started talking about personal finance with my colleagues, one of them proudly stated, “Investing is super easy. Just put your money in ETFs and forget about it.” That isn’t exactly terrible advice on the surface, but when I asked him what ETF he invested in, he told me all his money was in QQQ.
QQQ is an ETF that tracks the NASDAQ 100, or the 100 largest stocks on that exchange. Given the current composition of the NASDAQ, where 50% of the top 100 stocks are technology companies, this is essentially a large-cap technology fund. Other index funds track individual sectors rather than the whole market, such as healthcare or consumer staples, which is the opposite of diversification.
A financial services company can create an index fund or an ETF from anything. If you want a triple-leveraged S&P 500 ETF, there is one: if the underlying index goes up, you make 3x your investment, but if it goes down, you lose 3x (all while paying a higher fee due to the leverage). You can even buy an ETF tracking Bitcoin, which is akin to gambling.
Don’t make this mistake. Just because something is labeled an “index fund” or an “ETF” does not mean it is diversified, non-leveraged, or has a low expense ratio. You must know what the index tracks and understand that Wall Street has co-opted these terms to use against lay investors.
Fund Type 3: Hedge Funds
Many people think of hedge funds as a secretive investment for the rich, and, well, they’re right . . . sort of. Hedge funds are actively managed, private investment funds that allow accredited investors to participate. Managers seek high returns, engaging in complex and risky trading strategies to justify their enormous fees.
You may have heard of some famous, fabulously wealthy hedge fund managers. Do the names George Soros, Ray Dalio, Steve Cohen, Carl Icahn, John Paulson, Ken Griffin, or Bill Ackman ring any bells? They are all current or former billionaire hedge fund managers. How did they get so rich? Hedge fund managers typically charge “2 & 20”, meaning 2% of AUM annually plus 20% of any portfolio gains.
Hedge funds are designed to take big risks. If you make money, managers get their 2 & 20. If they lose money, they still get 2. They are incentivized to accumulate a large amount of assets under management and swing for the fences. Famous managers with proven track records aren’t going to take money from lowly medical professionals. We simply aren’t rich enough. However, there are a whopping 33,000 registered hedge funds in the U.S., so you can probably find an unproven manager willing to take your money and gamble with it. Good luck.
Comparing Actively Managed Mutual Fund Returns vs Index Funds
The performance of mutual fund managers is typically compared to a benchmark, usually the S&P 500 (the 500 largest U.S. companies) or the Wilshire 5000 (the total U.S. stock market). For a mutual fund to justify its fees, it must beat its benchmark’s returns by more than it charges in fees. If the S&P 500 returns 10% in a given year, a mutual fund that charges a 1.5% annual fee must return more than 11.5% to beat the market. That should be easy for a professional mutual fund manager, right? Right?
Unfortunately, there is no evidence that the mutual fund managers can consistently beat the market net of fees. This isn’t just my opinion. A 2013 study confirmed it. In 1970, there were only 358 mutual funds from which you could choose. Of the 358 mutual funds available in 1970, only 84 survived until 2013. That means 274 of 358 were closed during the 43-year study period. Let me tell you a secret: Mutual funds that perform well, making money for the managers and investors, don’t close.
Of the 84 that survived, only 35 beat the market, and only 4 beat it by more than 2% annualized. So, if you randomly picked a mutual fund in 1970, you would have received less than market returns 90.2% of the time, with 76.5% of the time the funds performed so poorly they had to close. Only 9.8% of the time did the mutual funds match or beat the market, and only 1.1% beat the market net of a 2% fee, which was common at the time.
This study has been replicated in various forms over time. A 2023 report showed that 88% of active managers failed to beat the market over a 15-year period. Today, there are over 7,200 mutual funds in the U.S., making it even harder to choose correctly. So, even if there are a few dozen “super stock pickers” out there, how do you find them in the thousands of mutual funds available?
Finding a mutual fund manager that can beat the market is like finding a needle in a haystack. It’s much easier to just buy the haystack in the form of a broad-market index fund or ETF.
That’s it for Lesson Four. I hope you learned why, for the average investor, broad-market index funds are the way to go to build wealth over your investing career. Hedge funds get the hype, and actively managed funds make the promises, but boring old diversified index funds actually deliver the returns over time. Leave your questions and comments below, and subscribe to the blog so you don’t miss any upcoming installments.