Investment Playground.NET

With the advent of technology, sometimes it might feel better to avoid purchasing individual stocks and instead just “buy the entire market”. Is this possible? With index investing, it is. Index investing is one method to avoid the madness of Mr. Market, and slowly watch companies’ earnings grow over time. Indexes such as the S&P 500 are the benchmarks which mutual funds compare themselves against. If a mutual fund manager earns 10% in any given year - but the overall indexes have earned 20% - this guy might be on his way out the door (with a grossly large and undeserved bonus). After all - he underperformed the market by 10%.

Outperforming the market or picking phenomenal stocks every time is not easy. Very few people have succeeded. This is precisely why a staple in every investors’ portfolio should be an index fund. The easy way of understanding indexes - basically they are the entire market.

All the stocks in the entire market trade in what is called an index. An index is not an individual stock, but a basket of many different stocks. The weighting of each stock depends on their market capitalization - a complicated term describing “size”. The Dow Jones - the thing everyone talks about - is itself an index. You can not buy the Dow Jones - it is simply an indicator of how 30 carefully selected companies are all together performing. The S&P 500 is a summary of the top 500 companies trading in the markets (those 500 companies are decided by a board of really smart and overpaid people). NASDAQ is a listing of tech-related companies. The Russell 2000 is similar the S&P 500 - except for it includes 2000 of the top companies (rocket science, I know).

How do I invest in an index?

The short answer is that you can’t invest directly in an index, per se. But what you can do is invest in an index FUND - a fund developed which mirrors the index. These are not actively managed funds - they are simply computer programs that create a vehicle for you to dump your cash in. If the target index tanks - your index fund will sink as well. These are passively managed funds which have drastically lower expense ratios.

Can I make more money by having a computer do it for me instead of someone really smart?

Firstly, “smart” is relative. Making money doesn’t make you smart, it makes you rich. And being smart doesn’t always make you money. Most geniuses die before they’re 40, or end up on the streets because following the corporate game is “below them”. But I digress.

Here are the simple stats: since the 1929 crash, the market has returned an average of 11% per year. Some years its gone down 10%, others its gone up 20%. But if you stayed firm and held course, you always gained 10% annualized over eight decades. A mere $1000 investment into an index fund in 1930 would be worth $3.4 million today. There are some “smart” people who have done better, but generally not over several decades. Humans are emotional, and emotions drag down your returns. Investing in an index fund over a long period of time generally will make you enough money to be free.

How much do index funds cost me?

Because index funds are passively managed, they are signficantly cheaper than managed funds. An average managed fund’s expense ratio might be 1.5% (or others can go up to 4%). In addition, some funds carry a one-time “load” fee of 4.5% or so. Contrarily, index funds never carry higher than 0.5% expense ratios. Obviously, running a managed fund carries additional expenses. But you’ve got to achieve some pretty high returns in order to justify a couple percentage points of costs. Only the best managers return that much higher than the market every year (and that list keeps changing).

So how do I invest in an index?

Now the meat of the post. Check out this link at Vanguard’s website. Scroll down to the bottom for the stock index fund listing. You’ve got your S&P index fund, Total Stock Market Fund, High Dividend Yield Fund, International Stock Index, etc. With the repressed levels of today’s market, I recommend you buy into one or perhaps a few of these funds. Further I recommend you enroll in an automatic investing plan to keep on investing additional funds. History shows that over time, you’ll earn an average 10-11% annually.

Another option is what’s called SPDR ETFs. These essentially are index funds that you buy and sell just like stock. There are no minimums, but you do pay standard commission charges. I strongly suggest you put down larger amounts of money into a proper fund such as Vanguard. If you’re investing with $500 or so, maybe you shouldn’t be in the market quite yet. With that said - I did decide to purchase shares in the SPY, just to take advantage of the Dow at 11,300. Check out www.spdrs.com for more info on SPDR investing.

Time for another fund pick. I purchased the Fairholme Fund earlier this month. There’s a $2500 minimum and also an automatic investing option, which you all know I love. It’s so easy to just set up recurring deposits into your fund and watch your money grow. What I love about this fund is their investment theory mirroring that of the world’s best investors - Benjamin Graham, Warren Buffet, et al. This buy-and-hold strategy has been proven time and time again as the best way to maximize returns while minimizing risk.

The Fairholme Fund is a classic long-term value-oriented play. The managers invest in underappreciated assets of good companies that have long-term growth potential. Don’t expect any quick dot-com buy-ins here. Just like Warren Buffet ignored the entire dot-com era, the managers of Fairholme won’t buy into anything based on simply speculation, momentum, or solely growth. Investing in undervalued companies with a long-term outlook reduces volatility - which is great in a market like today. Bruce Berkowitz, the fund’s manager since inception in 1999, when on record several years ago with this quote:

I think our philosophy makes a lot of sense. We’re doing nothing more than what the wealthiest individuals in the world have done. We act like owners. We focus on very few companies. We try and know what you can know. We try and only buy a few companies which we believe have been built to last in all environments. We recognize that you only need a few good ideas in a lifetime to be fabulously wealthy…. We’re always trying to wonder what can go wrong. We’re very focused on the downside.

Berkowitz runs a tight shop. Over 70% of the fund’s assets are in only 10 companies. It’s non diversified - meaning they don’t try and offset risk with some diversification and asset allocation methods. Expert investors can invest non diversified - this is not for the average Joe trying to make it to next week. Berkowitz feels that diversifying your portfolio brings you closer to average returns, which is not what the Fund is pushing for. Instead, he simply refuses to lose money. Sounds like a great motto. In fact in interviews with him in the last eight years, he’s made references to the fact that his only mistakes he’s made were selling a position way too early or too late, but never by buying something that didn’t return positively. It’s actually quite a simple idea that’s not too hard to practice yourself. Every purchase you make, KNOW that this purchase will earn positive cash flow over the long-term as it has over the long-term history. Even when Bruce’s picks decline shortly after the purchase date, he’ll usually take that as a buying opportunity and load up even more (see Brasil Telecom).

Fairholme Funds hold quite a bit of cash. With the investment strategy outlined, this makes perfect sense. They won’t buy at all until they see the opportunity surface. Once it does, make sure to have enough capital to make an impact. Take Warren Buffet’s $35 billion, for example. Right now, about 17% of Fairholme Fund’s $8.5 billion in assets is allocated to cash, meaning they can dump nearly $2 billion into one spectacular opportunity if it really comes around.

Another 20% of the fund’s assets are invested internationally. Personally - I get excited just thinking about international. I’ve got thousands tied up in the Middle East, Africa, and Brazil. The returns are just better there. Of the remainder, the Fund is particularly heavy in financial companies, energy, and media companies. Financial stocks, as an example, is one sector you’re guaranteed to cash in on as long as you have holding power.

Now the meat of it. The fund has returned 5.27% this year, outperforming the slumping market which fell about three percentage points. Annualized over the last five years, the fund’s returned 18%, trouncing the broader market’s 10%. They haven’t been right every time - but they have never lost money in any given year on record except for 2002 - down a mere 1.6% despite the market’s 20% bloodbath. This is a no load fund with only 0.6% expense ratio.

Lastly - go to their website http://www.fairholmefunds.com and look at the title of the page. Ignore The Crowd. They sold me the minute I saw that motto. Ignore what everyone else does - and just buy good companies at cheap prices. You’re bound to make millions.

My entry point was on May 1st at NAV $32.77. In total I’m up 2% for the month of May, 24% annualized.

After my son was born three weeks ago - a thought occurred to me. Life is only now beginning. And I’m referring to the financial definition of “life”. Sure I’ve had tons of expenses up to today, but now is when money all of a sudden seems to disappear. I’ve had student loans, car loans, rent, and whatever else - but tack on college fund ($100 p month), diapers ($125 p month), doctor visits ($20 copay once p month), and once they get older - swim lessons (ridiculous amount per hour), tennis lessons (don’t get me started), and so on and so forth. So - all my hard earned money is only now getting thrown out the window.

Saving for investment takes the priority over any expense you can have. I made a decision within a few days after my son was born - a decision that was long overdue. I have to stop saving massive amounts, and start investing those funds. The reason is because returns grow exponentially over time. Every day you do not invest is a day you lose on huge compounded returns.

I bought stock into the T. Rowe Price Africa and Middle East Fund. It’s an emerging market fund, so risks are a little high, but nonetheless I’ve done my analysis and I’m comfortable with management and my money. I’m thrilled that I am finally securing some returns. My first real major investments were trading stocks. I’ve made several hundred dollars per year - but nothing crazy. Shortly thereafter, I bought an investment property. $182,000 with a value I estimated to be about $200k. And now, I’m continuing my stock investments and beginning my fund investments.

By making a few good stock picks, you may be raking in a few hundred dollars once in a while. Fast money, high stakes, great trades. We all know the game. But are you really building wealth? No - you’re not. A couple fast trades off of quick stock drops might buy you a few extra toys, but not wealth. I trade stocks because I enjoy it and because I love valuation analysis (label DORK here). I’m buying mutual funds to build wealth. Here are the numbers.

Saving a palsy $50 today will become $373 in twenty years by earning 10% (basically throwing it into an index fund and forgetting about it). And imagine with $5000… $37,254. That’s a one time expense for you and a 645% return (try that in stock-picking). Funds generally require about $2500 minimum. This may be a lot for some people, which is why I love T. Rowe Price’s Automatic Asset Builder plan. Minimum $50 per month, and you just keep growing your assets slow and steadily. I haven’t found anyone else that waives the $2500 minimum. But eventually you’ll get your $2500 and start to look at Vanguard, Fidelity, and American Funds. If you invest $100 per month into a fund earning 10%, you’ll have accrued $21k in ten years, only $12k of that is actually what you put in. And if you’re a bit younger and looking for higher risk higher reward (i.e. global stocks and emerging markets), a 20% return earns you $39k. $40,000 just for putting away $100 per month. At that point even if you stop putting money in and just let your returns build up more and more - you’ll have a million dollars by retirement. A million LIQUID dollars just for focusing on $100 per month for ten years in a good stable fund. Of course, all investments carry risk - but the longer your outlook - the better advantaged you are as your risk lessens.

Regardless of how much you have - start plowing it into some finely selected funds right away. If you’re a recent college grad - how much I want to just grab you by the shoulders and scream at you - DO THIS. It’s hard to think about the future when it’s more fun to think about today - but a little careful planning now could set you on the path to financial freedom tomorrow.

Investing in the stock market is hard work. Picking a stock that will return profitably is not easy. You’re looking for a good company, with good managers, and undervalued pricing. I buy very few stocks. There’s not a lot out there that’s worth buying, and I’m not a gambler at all. Even if you find a good stock, how much disposable income or savings do you have availabel to you to invest? The typical retail investor plays around with less than $5000, and many people buy and sell with just a thousand or so. There are three problems with this:

1. Commission fees on a percentage basis are much higher than you want to be paying.
2. Absolute returns are much lower than you expect.
3. Forget about the possibility of diversification.

As an example, let’s say you have $1000 to invest, and let’s say you’re investing through Scottrade (the cheapest commission of $7 per trade). Let’s say with your $1000 you buy 19 shares worth of a $50 stock. The stock goes up 10% in the next eight or nine months to $55 per share and you sell. Great move - the market returns an average return of 10% over many decades. But 10% return of your $950 investment is merely $95 - not enough to retire off of. Plus your $14 in buy/sell commission fees eat into that $95 return by 15%. 15% of your earnings are gone! That’s like getting the world’s worst car loan.

And as far as the diversification aspect goes - you’ll need another several thousand dollars to balance your portfolio nicely instead of fully allocated to one single stock (way too high risk).

Bottom line - pay the mere one or two percent fee to a money manager who will invest your money for you. You’re safer and will inevitably have a much higher return.