I get a ton of emails from readers asking a version of the following question: “I have $X to invest. What should I invest in?”
It’s not a question I can answer with so little context. But I would like to help you answer that question yourself through a series of posts on the topic, and I’ll start with my favorite strategy.
If I pass away and have to leave my spouse and children with one set of instructions as to how to invest, this would be it. I believe everyone should walk through their different investment options carefully before deciding on a strategy, but I suspect this one will represent the best balance of returns, effort required, and ease of understanding and would be the investment of choice for at least 75% of people.
The strategy is this: Invest in low-cost index funds.
What Is an Index Fund?
An index fund is a specific type of mutual fund whose portfolio is constructed to match or track the components of a market index, such as the S&P 500. In general, index funds are generally described as investments that provide broad market exposure, low operating expenses and low portfolio turnover (buying and selling of stocks in the portfolio).
Why Choose an Index Fund?
A low cost index fund such says “I have no idea which stock is better than another.” Instead, it buys shares of every stock in the market in proportion to their market cap, and their whole job is just to mirror movements in the market. Buying a low cost index fund is saying that you are betting on the broad, long-term prosperity of all US-traded companies.
Is this a good bet? History would say so. The compound annual growth rate of the S&P 500 from 1950 to 2016 was 11.27%. The last two years have looked less promising with a CAGR of 8.35%, but still very solid. The compound annual growth rate strongly depends on whether you start in a really terrible year (15-20%+ declines) or not, but over pretty much every long stretch of 20+ years you will see high single digit or low double digit returns.
Of course, past performance is no guarantee of future performance, but it is is one of the strongest indicators an investor can use to get a rough range of what outcomes they might see.
The nice thing about index funds is they tend to be extremely low cost. Because the money manager’s job is just to mirror an index, they can keep costs below, often below .05% a year. That means you, the investor, get to keep as much of the gains as possible.
Current Events Update
When I deploy an investment strategy, I like to think about what if anything about today’s environment will affect my returns differently compared to historical periods. I’ve written a little bit about my prediction of stock market returns here, but you may want to think about your own views and whether the returns adjusted for your views make this still a promising strategy for you.
Overall, I think of a low cost index-fund strategy as still quite apropos for an aspiring retiree in today’s environment.
An index fund strategy is a long-term strategy, which means you ideally will have at least 10 years of runway to let the strategy do its work. Note that this does not mean if you plan to retire within 10 years that you can’t have index funds in your portfolio, but it does mean you may want to consider an allocation of your portfolio (i.e. less than 100%) that does not require you to sell chunks of your index funds every year to make ends meet.
Some retirees get by flagrantly defying this rule. It really has to do with when and whether you see a downturn – if you retire into a giant bull market, you’ll look at your returns and have no reason to believe that you need to have your money working in the strategy for 10+ years. But if you happen to be the unlucky cohort that dumps your money in right before a downturn where you see real trouble if you were planning on selling chunks of your stocks every year. Fortunately, historical data shows you should still be just fine and generate respectable returns as this unlucky cohort, as long as you don’t pull the money out while it’s down. Those dollars need to stay deployed while the market is relatively attractively priced and poised for recovery. That’s why you should plan to leave the money untouched for 10 years or more; it’s for the situation in which there’s a major downturn and you don’t want to have to sell undervalued stocks just to make ends meet.
For the basic strategy, I recommend the following funds. Each pair (Vanguard vs Fidelity) is virtually identical in composition and long-term returns. They are also virtually identical in cost (less than .05% expense ratios).
VTSAX – Vanguard Total Stock Market Return – Admiral Shares
FSTVX – Fidelity Total Market Index Fund – Premium Class
VIMAX – Vanguard Mid-Cap Index Fund – Admiral Shares
FSCKX – Fidelity Mid-Cap Index Fund – Premium Class
For the avid thinker, there are a million different ways to optimize against an index fund strategy. Some of them can affect your overall returns by several percentage points, which can amount to hundreds of thousands of dollars. Not all indices are created equal. Perhaps you want an S&P index fund over a total stock market index fund. Or perhaps you want the NASDAQ over the S&P 500. Those will take longer to discuss than we have time for in this post but there is a deeper discussion of that here.
One easy optimization to consider right off the bat is to consider ETF’s over their index fund counterparts.
Many major index funds have an ETF – exchanged-traded fund – counterpart. The major difference is that 1) exchange traded funds can be bought and sold intraday, whereas a mutual fund only trades once at the end of each day 2) the Vanguard ETF-equivalents do not have minimum investment amounts to enjoy the advantaged, lower expense ratios of Admiral Shares. More flexibility and less restrictions are net positives to me, so I generally prefer the ETF equivalents (i.e. VTI over VTSAX, VO over VIMAX).
Finally, if you find the thought of considering these optimizations overwhelming, that’s okay. Don’t let the myriad of options paralyze you. Come up with a plan for how much time you want to invest in making a decision, what bar you’d need to hit to consider something unorthodox, then get your research done and pull the trigger.
The low-cost index fund strategy serves as an excellent benchmark for evaluating investment strategies and may in fact be the best choice for your own strategy. Over the next few months, we’ll cover more nuances of this strategy such as different twists based on the same fundamental thesis that offer different risk-reward ratios.
This is a beefy topic. What further questions do you have about this strategy? What have been your experiences? I consider this an opening salvo on the topic and would like to build a post with answers to any follow-up questions. Let’s make this a solid resource for everyone considering it.
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