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The Stock Market’s Dirty Little Secret

Enjoy this post today about investing by blogger and Chartered Financial Analyst Joseph Hogue.

I have built my career around investing and analysis of investments. I’ve done a good job and am proud of the advice I’ve offered clients but there is a dirty little secret that most analysts will not talk about.

The secret…many investors may not even need us.

Analysts are able to provide valuable information on stocks that helps keep the market so efficient and running smoothly. While it is difficult for anyone to “beat” the market consistently year-over-year, research shows that some analysts have been able to earn higher returns after adjusting for risk.

But the problem is that many investors just don’t need the few extra percentage points in returns that stock market analysis can provide.

Why would anyone pass up extra investment returns?

If actively analyzing your investments can lead to an extra percent or two of return on your portfolio, why wouldn’t you look to analyst advice? After all, an additional one percent every year can mean a lot more after 30 years of compounding.

There are two problems with active management of your investments. First, you’ve no guarantee that the analyst’s advice is any good or going to provide that extra return. It could take years to find a money manager or analyst that is able to align your need for return and risk tolerance. If you are picking your own stocks, you will have to spend hours finding the right ones and expose yourself to all kinds of behavioral traps like panic-selling.

The second problem with actively investing your money (i.e. buying and selling individual stocks instead of just buying and holding some index funds) is that most investors just don’t need the headache. Stocks in the S&P 500 have booked a 7.2% average return over the past 30 years. Investing just $500 a month in the index would have grown to over $600,000 over the past three decades. That amount isn’t enough to live in the lap of luxury during retirement but is well over the $255,000 average most people 55+ have in their 401K plans.

Besides doing relatively well on the return, consider that you didn’t have to spend hours a week picking stocks or worrying about the next market meltdown. After two market crashes just in the past fifteen years, not having to worry if you’re in the right stocks at the right time is priceless.

Your Whole Portfolio in Three Investments

While you may not need to pick stocks for your investment portfolio, I wouldn’t recommend putting everything in the S&P 500 either. Stocks will still leave you exposed to a roller coaster ride of returns and you need some diversification to even things out. Spreading your investment across different asset classes like stocks, bonds and real estate evens out your risk without sacrificing too much return.

Enter exchange traded funds (ETFs). If you haven’t heard of ETFs, they are basically just mutual funds that trade like stocks. The fund holds individual stocks and bonds depending on the investments it seeks to track. Most ETFs charge management fees well below that charged by mutual funds and you only pay taxes on the gains when you sell the fund, unlike mutual funds where you pay taxes every year on distributions.

There are thousands of ETFs but most likely you’ll only need a few to give you exposure to the major asset classes. In fact, investing in just three ETFs provides diversification across the three main asset classes and one of the easiest investment strategies I know.

Bonds – Loans to corporations or government entities are the safest portion of your portfolio and provide cash on a regular basis. If you hold them to the final payoff then the overall return is known except in cases of default. ETFs that offer exposure to bonds are the iShares Core U.S. Aggregate Bond Fund (AGG) and the iShares iBoxx Investment Grade Corporate Bond (LQD).

Stocks – A share ownership in public companies offers the upside of higher returns but also greater downside than bonds. There are ETFs that cover every type of stock investing but most investors will do just fine with a general stock fund like the SPDR S&P 500 ETF (SPY) or the Vanguard Total Stock Market ETF (VTI).

Real Estate – Despite the last decade, real estate has historically been a great investment and the NAREIT Equity Real Estate index has returned over 11% annually over the last 30 years. Real estate investment offers regular cash dividends and diversification in a portfolio of stocks and bonds. The Vanguard REIT ETF (VNQ) and the SPDR Dow Jones International Real Estate (RWX) both provide good overall exposure.

You may choose to buy and hold a few more funds that just three but you really don’t need many for a diversified portfolio. Each ETF will hold hundreds of individual investments and will approximate the return across the entire sector.

If you enjoy analyzing the stock market and individual companies, then by all means continue to buy and sell individual stocks. Investing can be fun and there’s always the opportunity to find the next big stock.

Consider placing a large portion of your portfolio in a few ETFs and investing a relatively smaller sum in individual stocks. Whether you want to actively invest in stocks or not, don’t believe the media hype that you need to follow the advice of an analyst. Understand your options and how to put together a diversified portfolio with just a few investments you hold for the long haul.

Questions: How diversified is your portfolio? Are you investing in bonds and real estate? What has been your experience with ETFs? What other issues do you see with active management of your investments?

Author Bio: Joseph Hogue, CFA runs PeerFinance101, a blog where you share your stories of personal finance challenges and success. There’s no one-size-fits-all solution to meeting your financial goals but you’ll find a lot of similarities in others’ stories and a lot of ideas that will help you get through your own challenges.

Next Post: Why Godliness With Contentment Is Great Gain

Prior Post: How to Make a Good Decision Every Time

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Comments

  1. Brian, I got the dirty little secret. I was like oh my really? That being said, there are many people especially who are new in investment hire their own advisers.
    Jayson recently posted…Don’t Become A Statistic of Generation RentMy Profile

  2. So what’s the dirty little secret? Didn’t get that. Attention grabbing headline, no substance.

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