Benefits of Low Cost Investing

They add up

Disclaimer: I am not a financial advisor. The purpose of this post is simply to encourage others who want to learn more about managing their own investments.

Previously, I suggested that more people should consider managing their own investments because it is Easier Than You May Think, and it's like having a very part-time job with a very high compensation rate. If you're considering doing this, you'll want to find an investment approach that aligns with your financial goals. My goal is to be sure that my wife and I have enough money to support our comfortable lifestyle now that we're retired. 

This post compares two investing approaches. Some might consider these summaries over-simplified, and they probably are, but they'll provide a good foundation for readers who want to get started. The info isn't meant for people who've been managing their own investments for years, although I'd love to hear their input.

Vocabulary

• Stock: Ownership of a fraction of a corporation
• Mutual Fund: Collection of stocks from many companies; often focused on a specific market segment or industry. e.g. Emerging software, specialized biotech, or telecommunications. 
  Note: For simplicity, I use the term "mutual funds" below to refer to both mutual funds and Exchange Traded Funds (ETFs). You'll learn the distinction between the two as your knowledge grows.

Approach 1: Traditional Investing
Traditional investing involves purchasing individual stocks and/or mutual funds based on various quantitative and qualitative considereations. Typical quantitative considerations include revenue growth, earnings, and current stock price. Qualitative considerations can include things like industry trends, market dynamics, and even cultural shifts. You'll want to ask yourself questions like, "Are people drinking fewer soft drinks as they become more health conscious?", "Are brick-and-mortar stores disappearing as people do more online shopping?" and "Are others likely to copy the Uber model and apply it to different consumer services?" Then you'll want to identify companies that are likely to succeed. "Success" will probably be defined differently by each company. It could involve profitability, growth, innovation as well as other things. In the end, you'll want to purchase stocks that the market thinks will do "well" (since the market determines the price of the stock).

The benefit of this approach is that there is potential for large gains ... if you buy the right stocks and/or mutual funds.

The risk associated with this approach is that there is potential for large losses if you pick the wrong stocks and/or mutual funds. 

Some people don't like the potential volatility and risks associated with owning individual stocks because the possibility of large gains is coupled with the risk of large losses. To reduce the possibility of extreme outcomes, some invest, at least partially, in mutual funds. Just like stock, you'll want to do some research before selecting mutual funds. You'll want to ask yourself (and research answers to) questions like: "Do I think software is poised for a big gain?" and "Since electric vehicles seem hot, should I find a mutual fund that focuses on those?" You'll also want to ask yourself: "Is this particular fund being managed by someone with a good track record?" and "Is the fund efficiently managed?"

In Summary
Traditional investing delivers the possibility of large gains (e.g. Tesla has risen 7,000% in 2020 as of today). It also requires:

1. Considerable research (i.e. your time)
2. Good luck (i.e. many factors that cause a company to succeed or fail are difficult to accurately predict; think COVID-19 and 9/11)
3. An ability to handle large losses (e.g. SolarWinds, the company at the center of a recent US Government computer breach, has seen their stock drop 40% in just one week)

Approach 2: Low Cost Investing
Low cost investors focus on purchasing mutual funds instead of individual stocks, and they specifically look for mutual funds with low fees and operating expenses. (Since mutual funds require specialists to create and manage them, there are management/operating costs and fees associated with them.) Low cost funds are set up to run with very little management by humans. This is achieved by creating funds whose components mirror common market indices such as the S&P 500 and Nasdaq (thus the term "Index Funds").

The benefit of low cost investing is that it usually delivers consistent, moderate returns over long periods of time. And those returns add up.

The downside of this approach is that big increases in value in specific companies or even market sectors rarely result in dramatic gains to an indexed fund.

In summary
Low cost investing is most likely to produce steady, moderate gains instead of rapid value fluctuations. It's less exciting when the market rises quickly and less scary when the market drops quickly.

Which Style Is Right For You?
Some people prefer traditional investing because it's easy to understand and/or they enjoy the "thrill" associated with it. Personally, I'm not a fan for the following reasons:

1. High cost mutual funds require higher returns before they become a good investment. i.e. The fund needs to return enough to provide you with a profit and cover the fund's expenses.  Many believe that active (i.e. expensive) management is required in order for a fund perform better than the market average, but research and history show that actively managed funds rarely outperform the market consistently.
2. There is more stress watching a portfolio of stocks and high cost mutual funds because it's likely to experience larger swings in value than a portfolio comprised of index mutual funds.
3. Good luck is often required for success. Good decisions are easy to make in hindsight, but a lot harder to make in the moment. People who purchase stocks and funds that increase drastically do a lot more talking than people whose decisions don't pay off or even end up costing them.  For example: Solar energy is pretty hot. It's growing quickly and seems like a slam dunk ... unless you invested in First Solar, which has lost 60% in the last 11 years.

The "father" of low cost investing is the late John ("Jack") Bogle, the founder of Vanguard.  Bogle's philosophy for investing and building wealth includes investing in low cost funds, investing early and often, and keeping investments simple, among other behaviors.  Information about the Bogleheads® investment philosophy makes for interesting and valuable reading.

Low cost investing methodologies are unlikely to enable you to tell dramatic financial stories at cocktail parties. (e.g. You won't be able to talk about buying Tesla at $14/share now that it's at $695/share.) But Low cost Investing may mean you no longer need to work when you're 70. (And it may prevent you from needing to lament, "I was absolutely positive Enron was my ticket to early retirement.")

-- Jim

Related reading: 

•  Easier Than You May Think