Investing 101: Stock picking vs. Index Funds, Expense Ratios, and Automation

Hi all, today I’d like to offer a great starting point for new investors, and that is Betterment. Before we get into what Betterment is and why I recommend it, step number one in all investment strategies in my opinion should be trying to max out your 401k. If you’re not enrolled into your employer’s 401k plan (or 403b if you work for a non-profit), you need to do that immediately.  All of the tax benefits alone make it the best investment vehicle for your money.

Assuming we’ve crossed that off the list, there may be reasons why you’re investing money outside of the 401k.  There is a yearly limit to how much you can contribute to a 401k ($19,500 in 2021), so perhaps you have more income to invest than is allowed.  You may wish to take advantage of the tax benefits of an IRA.  You may also want to keep assets available for withdraw before 59 1/2 (the age at which retirees can start to withdraw from a 401k).  Perhaps you’re planning on using the funds or just want to retire early.  Regardless of the situation, if you have money you want to invest outside of the 401k, I always recommend Betterment as a way to get your feet wet.  Even if you don’t have extra money to invest, a lot of the lessons here apply to the funds WITHIN your 401k, so keep reading.

Don’t stock pick!

The most common mistake that amateur investors make in my opinion is picking individual stocks.  There’s a lot of great stories out there.  Guy invests $1 in Microsoft in 1955 when Bill Gates is conceived and owns shares of the company before it’s even launched.  Man is now worth trillions.  We’ve heard them all before.  This one is true: I worked with a guy who made 30% on his money one year picking individual stocks.  That’s awesome!  Will he keep that up over the next 30-40 years of his working life?  That COULD happen, but let’s be honest, it probably won’t.  More likely than not, you’ll end up wasting hours of your life just to underperform in your investments relative to the strategy I’ll share below.

The other downside of picking individual stocks is the emotional rollercoaster it takes you on.  In the digital world, the bad news is always swirling.  For every positive or bullish story on the markets, there are 10 more in the opposite direction if you look for them.

We’ve all likely heard this advice before, “buy low, sell high.”  Unfortunately, the part-time investor can’t help but do the opposite.  When there is good news, investors are buying. When there is bad news, investors are selling.  Company X is up 150% this year? It’s a hot stock, get in while you can.  Oh, Company Y is down 20% so far this quarter?  Sell now before you lose it all.  That is buying high and selling low, exactly the opposite of what you want to be doing.

I personally do not have the stomach to pick individual stocks.  I could not help but check up on news for the companies that I was invested in.  And it was stressful.  And quite frankly a huge waste of time.  I put a few thousand dollars into individual stocks early in my investing career, and it was a great learning experience.  Most were okay, I invested in a lot of blue chip stocks, such as Disney and Apple.  At the recommendation of a friend, I invested about $1500 in GoPro for around $40 per share in 2015.  Check out where they were trading as of September 2017 (when I finally cashed them out):

Yikes…

But that’s just average investors, people like you and me. The investment bankers and hedge fund managers are probably good at it right? I mean, they make millions for a reason.

Over the 5 year period ending on June 30th 2020, 77.97% of Large-Cap fund managers failed to beat the S&P 500 index (https://www.spindices.com/spiva/#/reports).

The people who spend 100 hours a week analyzing companies, picking stocks, and investing with millions of dollars can’t beat the market. And if they can’t do it, what chance do you have?

A Better Way to Invest

This is where the index fund comes in.  An index fund is a fund that invests in a group of stocks being tracked by the “index”.  For example, the S&P 500 mentioned before tracks the largest 500 companies in the US. If a company drops to being the 501st largest company in the US it is sold and replaced with the new company that becomes #500. No input from a stock picker needed. There are a few benefits to this strategy that we’ll get into.

Performance

As we learned earlier, over 77% of fund managers can’t beat the index.  What does that mean?  77% of the time, the index beats the fund managers!  If you want better long-term performance, invest in the index funds.  As long as you stay the course, continuously invest and don’t pull money out when times are bad, you WILL end up ahead.

Check out the returns of the S&P 500 over the last 100 years plus:

s&p 500

Fees

Index funds are cheap.  Since they don’t require active management, the expense ratios are very low (the % of your invested funds that the fund manager charges as a fee).  Check out the expense ratios on your current managed funds or your target date fund in your 401k or brokerage accounts.  For example, before I knew any better, I had my 401k invested in a Target Date Fund from T. Rowe Price (PAROX).  The expense ratio sat at 1.01%.

By comparison, the Vanguard Fortune 500 Index fund (VOO) has an expense ratio of 0.03%!

Over the course of your working life, this could result in tens, if not hundreds of thousands of dollars in missed earnings being spent on fees instead.

Time

As I mentioned earlier, I have better things to do than analyze which companies are going to be worth putting money into and which ones I should stay away from. And as we’ve learned, that strategy usually doesn’t work anyway. If you invest in the indexes, you don’t have to spend nearly as much time on research.

Less Stress

Since you’re not invested in individual companies, you are not subject to the whims of the ups & downs of that individual stock. Things are a bit smoother. There will always be good times and bad times, but you’re not likely going to experience huge swings like you would trading individual stocks.  And once you truly understand and embrace the “get rich slow” mindset, you won’t be concerned about the short-term fluctuations of the market.

Hopefully by this point I’ve sold you on investing in index funds over picking individual stocks. Opening a brokerage account through a company like Vanguard or Fidelity and purchasing index funds is absolutely a possibility. However, in my opinion, there’s a better solution for the new or inexperienced investor.

Betterment

Before we jump in, let me just say, I am in no way affiliated with Betterment. I am recommending their service because I use it and enjoy it. Betterment is one of a small handful of companies that is revolutionizing the investment space. Through automation, Betterment is able to pass along cost-savings to their customers, while providing a lot of the same services that a fund manager would provide. Betterment’s management fee is a measly .25% compared to the 1 – 2% you’d see with fund managers. They are known in the industry as “robo-advisors”. I am specifically recommending Betterment over the others, as it is the one I have had personal experience with.

The biggest pro in my opinion of using a service like Betterment is the “set it and forget it” style of investing it affords you. As I mentioned before, if you are a somewhat knowledgeable investor, it’s not that difficult to open a brokerage account and purchase your own index funds. However, Betterment removes that step in the process. You just tell it what your goals are, your risk tolerance, and Betterment does the rest. It will automatically diversify your money in a variety of extremely low-cost index funds. Again, these are funds that have lower costs AND outperform the fund managers over the long term.

Here is a screenshot of my current portfolio within Betterment:

 

Some additional features I like to help the new investor:

 

Auto-deposit

 

One of the challenges new investors have is sticking with their strategy over the long term. Just as you may do with your 401k plan, pulling money out of your paycheck before you ever see it, Betterment allows you to do something similar. You can set a recurring deposit that will automatically withdraw from your bank account and be automatically invested across the different funds in your portfolio. Set it and forget it.

 

Advice tools

 

Betterment provides you access to tools that help you track progress to goals you’ve set within the platform.  One of my favorites being the “Retire Guide” to track your progress towards your self-selected retirement spending targets.

 

Tax Loss Harvesting

 

This is an automated process in which Betterment will attempt to reduce your tax burden by selling off losses (funds that have decreased in value). So when you report on your capital gains on your taxes, your burden will be less. This is possible to do on your own, but can be tedious. I personally have better things to worry about than the minutiae of tax loss harvesting, so I’m happy to let Betterment handle that for me. If opting for this service, make sure to do your due diligence to avoid what the IRS refers to as the “wash-sale rule”. Betterment will ask you a few questions to determine if the option makes sense for you.

 

Wrapping Up

 

To recap, index funds help you save oodles on fees AND outperform managed funds. And Betterment is a great way to setup a passive, hands-off portfolio in those index funds. The biggest hurdle for a lot of people interested in investing is getting started. Hopefully this shows you that it’s easy to understand and easy to get started investing and working towards your financial future.

 

Leave any questions you might have in the comments below, I’d love to hear from you!

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