Index And Chill

Dear boys:

Today I’m going to tell you why you should invest your hard-earned money in index funds, and keep it there.

As you grow up and look for ways to have your money earn you more money, you’re going to hear a lot of opinions. You’ll also find people online, co-workers, and friends claiming they know about the “next big thing”, why “this time is different”.

You’ll see and hear a lot of noise and chatter, designed to convince you why you’re different, special, and can somehow beat the market at its own game.

Your friends will also tell you about amazing money they’re making in a single stock/cryptocurrency/tulips/something else. Perhaps hovercraft or Fortnite coins? I don’t know what the “next big thing” will be, but I know that everyone but you will seem to be making money at it.

Your job will be to ignore the noise. Keep the bulk of your money in index funds and just use “play money” for alternative investments. In other words, just “index and chill”.

This is a series of letters to my children, ages 15, 11, and 3, about money, success, frugality, and financial freedom. I hope this series also educates my readers, and inspires you to have these conversations with children in your own lives.

Data-Driven Investment Decision

Why am I recommending index funds?

Because the data tells me so.

1. Index funds have better performance
2. Index funds have lower costs
3. People are terrible investors

Let me explain.

Better Performance

Warren Buffet famously bet that hedge funds couldn’t beat the S&P 500 over a period of ten years. And he won.

Over the ten year time frame, the performance of the unmanaged S&P 500 (with very low fees) was measured against five “fund of funds” of hedge funds (with very high fees). A hundred thousand dollars invested in the hedge funds at the beginning of the bet would be worth around $140k by the end.

Investing in the S&P 500, on the other hand, would have left an investor with over $200k.

But what if you’re not hedge-fund level wealthy – does this still apply to you?

Just check out SPIVA research. Approximately 76% of actively managed large funds have underperformed the S&P 500 in the past five years. The stats are even worse for mid- and small- cap funds, at 82% and 93% underperforming, respectively.

We like to think that we are different, unique, and special. That, of course, we can pick the “right” funds that will outperform the market. Because we’re smarter than average, and shouldn’t settle for average returns.

In investing, though, average is fine. Average is great! Ironically, average will get you above-average returns most of the time.

Tyranny Of Compounding Costs

Part of why Buffet won his bet was the lower costs of index funds. Cost is a huge component of overall investment performance and one that people tend to overlook when chasing higher returns.

As you start to learn about personal finance and investing, you’ll learn about the magic of compound interest. If you invest early enough, give your money enough time, and have enough of a return, eventually the power of your money to earn you more money will outstrip your job.

But just as your investment returns will compound over time, costs compound too. I highly recommend checking out this illustration of how a 2.5% fee can destroy your investment returns. If you think that’s an unrealistically high number for fees, then you don’t know that the average small 401k plan has fees of 1.5-2%. Some go as high as 3.5%.

It takes huge market out-performance to overcome that kind of fee load.

In addition to fees, don’t forget about taxes. Index funds are very tax-efficient investing vehicles. Actively managed funds often are not, making frequent distributions that you have to pay taxes on. Why? Because they’re traded more often.

Costs matter. Choosing low-cost investment options makes sense most of the time. And in the few times where it might make sense to pay for performance, you’re not likely to be able to identify.

People Are Terrible Investors

Part of being a successful investor is becoming aware of just how much you suck at it.

It’s not your fault. We all suck at it. This is why taking yourself and your behavior out of the equation will be more successful than trying to meddle.

I see an awful lot of people talking about “not settling for average” and trying to justify why their investment strategy/stock picking method/cryptocurrency/whatever is different. But facts don’t lie, and the facts say that most of us suck at investing because we just can’t leave well enough alone.

The average investor underperforms the market by a lot. Consistently. In 2017, when the S&P made almost 12%, the average investor underperformed by almost 5%.

Over a 30 year timeframe, which is pretty close to what most people will experience, the average investor made just under 4%. The S&P 500, on the other hand, made just over 10%.

How big of a difference is this? Lets say you start at 25, invest $1000 per month for 30 years, and then want to retire to a beach somewhere at 55.

With a 10% return you’d have just over $2 million.

With a 4% return you’ll have…$687k.

What’s the reason for underperformance? There are man. Costs are one factor, as is picking funds that simply don’t outperform the benchmark (like most don’t). But there’s also our endless attempts to time the market.

I saw this first-hand in the Great Recession, as well as recently in the Q4 downturn. People sold their stocks. They went to cash. They panicked, assuming the market would never recover. And many of those folks have missed the 6.3% upswing since January 1st.

Stop thinking you’re special and different, capture the average, and…

Index And Chill

There’s more to life than money.

Why spend time, mindspace, energy, and so on trying to pick the next big thing? If you decide you want to become the next Warren Buffet, then of course that’s a different story. But I expect that your career won’t be devoted to money management.

Whether you’re a business professional, artist, teacher, firefighter, doctor, or any other profession, you’ll have better things to do with your time. You might have a family you want to spend time with. You’ll want to have hobbies.

In other words, you’re not going to want to devote your precious limited time to figuring out how to beat the market. So just be the market instead.

Index and chill.

And move on with life.