Date Published: 6/2/2012

Hyllandresearch.com

A case for Index Investing and Patience

It sounds like a gimmick, but by following this article you can beat the return of more than two-thirds of mutual funds, and the majority of hedge funds and individual investors. The best part? The process is one of the cheapest and easiest ways to invest. In this article we look at the many investment choices available to individual investors and their role in your retirement portfolio. When deciding on an investment, the individual investor has two things to consider when deciding on a specific investment; the investments ability to 1) Protect capital and 2) Grow capital, with increased importance on number 1. Maximizing both these requires the investor to keep risk in check, costs as low as possible and be patient and persistent. We will touch on each one of these issues to determine the best route for the individual investor to save for retirement. Considering Risk When picking an investment, the investor has several choices to choose from for their stock allocation; among them are an individual stock, an actively managed stock fund or an index fund. Lets consider the pros and cons of each choice in an investors portfolio. Individual stock Here, the investor risks significant capital on one specific company. If an investor puts $10,000 into a specific stock, say Facebook, a large percentage of their portfolio will depend solely on Facebooks performance. If Facebooks stock goes to zero, they loose all their money. Individual investors have historically been poor individual stock pickers. The center for retirement research at Boston University has released multiple reports, all concluding the same thing. The average individual investor underperforms the general market, by 8.5% after fees. This means the average individual investor is obviously not solely in a stock

index fund, but is overweight individual stocks, and poor performing ones at that. Most individual investors risk too much of their portfolios on an individual stock, and when that stock underperforms, which it inevitably will, the investors returns suffer. Below are two charts of some of the most widely held stocks (Exxon Mobile, Apple, IBM, Google and Chevron in the first chart and Microsoft, Johnson and Johnson, United Technologies, Proctor and Gamble and McDonalds in the second) compared to the S&P 500 stock index. The chart shows the performance of these stocks over the last 6 months. The charts were created using Yahoo Finance, though many brokers and finance sites have similar charting features.

Is it surprising that 80% of the most widely held stocks are losing against the market so far this year? Not to the intelligent investor. Individual stocks may have a place in retirement portfolios, but only as a small percentage and if the companys financials are well researched. If you dont have time to read annual reports, quarterly earnings reports and listen to conference calls, dont kid yourself into thinking you are informed enough to risk significant capital in individual stocks. As mentioned at the beginning, a simple index fund will outperform two-thirds of mutual funds and the majority of hedge funds and individual investors. That is nothing to be ashamed about!

Stock Fund To eliminate risking too much of ones portfolio in a single company, investors can choose to buy a stock fund instead individual stocks. For a small fee asset managers will pool your money with other investors in the fund and use the money to buy many stocks. This keeps the individual investor more diversified, so the performance of one stock will not have as large of an affect on the portfolio. There are two main types of stock funds, active and passive (or index). In an active stock fund, the funds manager charges higher fees, because they are buying and selling stocks constantly, guessing what will perform well and chasing returns. As proven before, the individual is poor picker of stocks, and that goes for the majority of professionals as well. These funds come with higher fees (as discussed later), which also eat into investors returns.

In a passive fund, the funds manager tries to match the performance of a specific index by buying every component in the index and holding onto that stock for long periods of time. For example, an S&P 500 index fund, such as the exchangetraded fund (ETF) SPY buys every component of the S&P 500. There are funds to match the performance of the NASDAQ, Dow Jones Industrial Average, or any other stock index in the world. These funds do not claim to beat the market, only perform as close to it as possible. The purchases are not up to the decision of any specific fund manager, but solely up to the market. Because these funds do not require as much work as active funds, their fees are significantly lower and because they match the returns of the market, generally outperform the active fund. Lets compare some big name stock funds descriptions, expenses and performance compared to the market this year and see how they compare. SPY SPDRs S&P 500 index fund. The investment seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. The Trust holds the Portfolio and cash and is not actively managed; by traditional methods. Expense ratio of 0.10%. PSPAX Pimco StocksPLUS . The investment seeks total return which exceeds that of the S&P 500. The fund seeks to exceed the total return of the S&P 500 Index by investing under normal circumstances in S&P 500 Index derivatives, backed by a portfolio of Fixed Income Instruments. Expense ratio of 0.9% Notice the claim to exceed the S&P 500? Make a mental note that 66% of people who claim they can do that, fail to do just that. Lets see how PIMCO, one of the biggest names in Wall Street compares to a simple boring cheap index fund.

How can the individual investor possibly hope to top Walls Streets best and brightest? Buy an index fund and sit back. So easy it should be illegal. Incase you think I am just highlighting a bad year for the PIMCO fund, here is a comparison of the fund since its inception compared to the S&P 500.

An underperformance of 150% compared to a simple S&P 500 index fund. Not quite worthy of my money. Beware of any claims to outperform the market. Many funds may do it once or twice, however most fail to do it more than that. How many funds have beaten the S&P 500 for 10 years? The answer is astonishing. Out of 7,000 actively managed stock funds 8. Thats right, 8 funds have beaten the S&P 500 over the last decade. How about a PIMCO fund for small cap companies? Here we are going to compare: VTWO Vanguards Russell 2000 Index fund. The investment seeks to track the performance of a benchmark index that measures the investment return of small-capitalization stocks in the United States. The fund employs a passive management -or indexing-investment approach designed to track the performance of the Russell 2000 Index. The index is designed to measure the performance of small-capitalization stocks in the United States. It has an expense ratio of 0.22% PSCSX PIMCOs small cap fund. The investment seeks total return which exceeds that of the Russell 2000 Index. The fund seeks to exceed the total return of the Russell 2000 Index. It has an expense ratio of 0.69%. Lets compare PIMCOs attempt to beat that index:

Do your retirement a favor, place the large majority of the money allocated to stocks into an index fund and laugh all the way to the bank.

Costs The main reason these big name actively managed funds fail to match the performance of the market is their expenses. A 0.05% increase in expense ratios means $3,000 more in fees for every $50,000 invested over 20 years. Then, after considering the return you could get from that $3,000, means that for every 0.05% in expense ratios you give up nearly $9,000! (This assumes 9% return on that $3,000). Even if those funds with higher fees could match the market, the investor would still underperform after taking fees into account! Also under costs, we need to briefly talk about the effect of taxes. Other articles have touched on this topic in more detail. Consider this bit from a previous article: Compare below the final balance after investing $5,000 a year from age 25 until age 65, with the historical market returns (factoring in stock price appreciation and dividends) in a Roth IRA compared to a regular brokerage account. Roth IRA: $381,400 Traditional Brokerage Account: $184,570

This assumes a 28% tax rate, which may be higher or lower depending on your income, however the results clearly show how compounding interest in combination with tax-free investing is beneficial! Your final investment total more than doubles with a tax-free Roth IRA!

An investor can more than double their returns by investing in tax-friendly retirement accounts such as a Roth-IRA. Combining tax friendly investing with lower fee stock funds, the individual investor can make the most of savings and ensure their growth for retirement.

Patience (and persistence) Many investors listen to the news today and see the times as too scary to invest, and pull their money out of stocks or worse, stop contributing money into stocks into a retirement account. The emotion of fear is a strong one, but often that emotion leads investors down the wrong path at exactly the wrong time. As solid companies are becoming cheaper, they are selling, only to buy back months or years later when the stock has increased in price. To see the effects of this in detail lets look at the worst financial decade in history, and how patience and persistence paid off for investors during the great depression. Consider an investor who purchased $10,000 into the S&P index fund in September 1929, just one month before the beginning of the great depression and the worst decade of U.S. stock performance in history. 10 years later, in 1939, their investment would have been worth about $7,200. In fact, they would have had to wait 25 years (1954) for the value of their investment to get back to $10,000! But consider a patient and persistent investor who invested $100 a month into that same S&P index starting in 1929 for the next 10 years. In 1939 their investment would have been worth more than $15,000! A disciplined, patient and persistent investor can make money even in the midst of the worst economic climate history has seen! We can relate this to a more recent example, the tech bubble of the late 90s and early 2000s. Where stock markets plunged. Many investors lost 90% of investments by buying in with all their money at the top, and holding all the way to the bottom. Consider an investor who started with $3000 and invested $100 a month starting in 1999.

This return is highlighted in the commentary of Chapter 5 in Benjamin Grahams The Intelligent Investor and the Vanguard group provides data. Even though the S&P went from 1470 to 879, an investor who invested wisely fared fine. Do your retirement account a favor, turn off the news, sit back, relax and keep contributing to your retirement, no matter the headlines.

With all these lessons in mind, the individual investor can easily beat the majority of investors on Wall Street. During the more recent financial crisis Jack Bogle, the founder of Vanguard Group, calmly came on CNBC with a quote that has been one of my favorites since he spoke it. The quote was perfect for then, is becoming more and more relative for today and great for ending this article with. My rule and its good only about 99% of the time, so I have to be careful here when these crises come along, the best rule you can possible follow is not Dont stand there, do something, but Dont do something, stand there!