Here are just a few of the ways Wall Street pros try to eke out an edge in the market. You can’t do any of them:
With a subscription to the Bloomberg online news service (price: about $20,000 a year), traders can instantly see anything from the location of oil tankers around the globe to supply-chain maps of a company’s vendors and customers.
Hedge fund managers who invest in drug and technology companies tap into “expert networks” of executives and scientists paid for their specialized knowledge. In some cases, it’s been charged, traders have also illegally gotten inside information through these contacts.
Half of stock trades are made by automated “high-frequency” programs; it takes 7/10,000ths of a second to buy or sell on the New York Stock Exchange, says the Tabb Group, down from a horse-and-buggy 10 seconds eight years ago.
You can’t get a jump on this crowd. You can’t even compete with them. Chances are, the professional managers you hire via a mutual fund, for 1% of assets or more per year, won’t be able to stay ahead either.
In October, Ray Dalio, one of the most successful hedge fund managers in the world, told a conference audience that “going forward, most investors are not going to be able to produce alpha.” “Alpha” is finance jargon for outperforming the market after accounting for risk. In truth, the search for alpha has always been something of a snipe hunt; the word was first used in a 1967 article that showed that most mutual funds didn’t deliver it, especially after subtracting fees.
Two things have changed since then: More pros admit the alpha game is over, and perhaps more important for you, investing has never been better for those willing to stop playing. In the words of Tadas Viskanta, editor of the finance blog Abnormal Returns, there’s wisdom in reaching for “investment mediocrity.”
Today, just as in 1967, most professionals can’t beat an index that tracks the stock market. “The paradox,” says Viskanta, “is that the less effort you put in, the better off you are.” And recently, he notes, perfect mediocrity has grown more attainable, as index-based investing has moved steadily closer to free.
For as little as 0.04% of assets per year — that’s $4 for every $10,000 you’ve invested — and often with no broker commission, you can buy an exchange-traded fund, or ETF, that follows most of the U.S. stock market and delivers its return.
This year’s Investor’s Guide starts from the idea that index funds and a buy-and-hold stance should be the default approach for long-term wealth builders. With that in mind, MONEY has rebuilt our basic investing tool set: Our list of recommended funds is now the MONEY 50, streamlined from 70. Not all the funds are index trackers, but the core choices are low-cost, highly diversified portfolios for the long run. For many investors, a portfolio balanced among one broad U.S. stock fund, an international fund, and one or two bond funds is all you need. The MONEY 50 makes building that portfolio easy.
Yet even if you decide to stick with a simplified strategy, that doesn’t mean every investment puzzle you’ll face has been solved. The stories in this guide will help you think through your approach to the three biggest questions you still face as you save for retirement.
Question No. 1: Buy and hold what exactly?
You can build a simple portfolio for any level of risk. Stretching for high returns? You could put all your money in the Schwab U.S. Broad Market SCHWAB STRATEGIC T US BROAD MKT ETF SCHB -0.47% , or crank up risk and return potential further by adding funds like Vanguard Small-Cap VANGUARD INDEX FDS VANGUARD SMALL-CAP ETF VB -1.12% or Vanguard FTSE Emerging Markets VANGUARD INTL EQUI FTSE EMERGING MKTS ETF VWO -0.76% . Need safety? Stash more in Vanguard Total Bond Market VANGUARD BD IDX FD TOTAL BOND MARKET BND -0.28% or iShares Barclays TIPS Bond ISHARES BARCLAYS TIPS BOND FUND TIP -0.43% to add inflation protection.
These funds make security selection automatic, but they don’t help at all with the question of how much risk you want to take. The standard rule of thumb says you should start out with a high allocation to equities and gradually “glide” that down as you age. These days fund companies often focus less on their stock-picking prowess and more on designing all-in-one “target date” funds that do this asset allocating for you. Yet as you’ll see in “How much should you hold in stocks?,” the theory and practice of lifetime asset allocation are all over the map.
Question No. 2: What if high stock and bond returns are really over?
If you’re a just-own-the-market purist, you don’t ask if stocks are cheap or expensive. You assume it’s too hard to outwit the hive-mind intelligence of the crowd. Over the short run that’s almost certainly true. But there’s evidence that the price of stocks relative to measures of their value like earnings and assets can provide a clue about returns over the course of a decade.
Stocks are now priced at about 21 times the five-year average of their earnings. According to research from the Leuthold Group advisory firm, when the market’s price-to-earnings ratio is between 20 and 25, over the next 10 years stocks have delivered an annualized return of only 3% after accounting for inflation.
Combine that with a gloomy outlook for bonds. Current yields are an indicator of future returns, and with the 10-year Treasury at 2.8%, you may be lucky to carve out 1% after inflation. “Stocks, Bonds? In 2014, Think Cash,” will help you think through your strategy so that you can thrive in a world where today’s high-asset prices could repress tomorrow’s returns.
Question No. 3: Can I ever do better?
Maybe. Even some advocates of index investing say there may be ways to outperform. But the extra bump doesn’t come from tearing into company balance sheets or, as famed Fidelity manager Peter Lynch used to say, “buying what you know.” It comes from “tilting” a portfolio of hundreds of securities to take advantage of anomalies that have shown up in historical stock returns.
One is the value effect, the tendency of stocks with low prices relative to their earnings or asset value to outperform over time. Likewise, there seems to be a small-company premium. For a shot at earning these boosts, you don’t buy a portfolio of 40 or 50 small-caps or bargain stocks. Instead, you buy an index or index-like fund that gives more weight to such shares.
You’ll need nerve: Larry Swedroe of Buckingham Asset Management, who recommends tilting, says the strategy trailed the S&P 500 badly in the late 1990s; in the past decade, though, an index of small value stocks earned an extra 2% annualized. “You have to be able to live through it,” he says.
“The New Faces of Stock Picking” profiles a pioneer in low-cost, tilted portfolios as well as other quantitatively driven thinkers searching for ways investors can carve out advantages. Instead of hunting for the inside scoop, they crunch data and use insights into investors’ behavioral blind spots. A caution: Now that star fund managers have faded, Wall Street is cranking out lots of ETFs. For every robust new idea, there’s likely to be a dozen more that are nothing but savvy marketing tied to a hot short-term trend.
Investing may be simple now, but you’ll still need the discipline not to chase the latest market beater, plus the patience to stick to a long-term strategy even when it’s out of favor. Simple? Yes, but not always easy.
OWN THE WORLD, FOR NEXT TO NOTHING
You can build a solid portfolio with just three investments. Here are examples using ETFs and index mutual funds:
The ETF route:
Schwab U.S. Aggregate Bond SCHWAB STRATEGIC T US AGGREGATE BD ETF SCHZ -0.23% : 40%
Schwab U.S. Broad Market: SCHWAB STRATEGIC T US BROAD MKT ETF SCHB -0.47% 40%
Schwab International Equity: SCHWAB STRATEGIC T INTL EQUITY ETF SCHF -0.07% 20%
The index fund route:
Vanguard Total Stock Market Index: VANGUARD TOTAL STOCK MKT INDEX INV VTSMX -0.41% 40%
Vanguard Total Bond Market Index: VANGUARD BD IDX FD TOTAL BOND MARKET BND -0.28% 40%
Vanguard Tax Managed International VANGUARD TAX MANAG DEVELOPED MKTS INDEX FD INV VDVIX -0.22% : 20%
Either way you go, your costs will be far, far less than most active fund managers charge…
ETF portfolio: 0.05%
Index fund portfolio: 0.08%
Three average active funds: 1.22%
… and you’ll be diversified across the globe.
Number of stocks:
ETF portfolio: 3,144
Index fund portfolio: 4,823
Three average active funds: 289