One of my best friend’s texted me the other day to tell me about a bet that Warren Buffet made ten years ago. He bet a hedge fund manager $1,000,000 that the S&P 500 would beat a basket of actively managed funds created by a Hedge Fund Manager at Protege Partners. Likely to no one’s surprise reading this website, Buffet won (he actually won more then the original million and doubled it). The S&P index fund compounded at an average annual interest of 7.1% while the hedge fund under-performed at 2.2% growth.
This reminded me of one of the best quotes from Jonathan Clements book (How to Think About Money) where he reveals why Buffet likely felt good about making this bet. From this quote you can derive what I call The Fourth Philosophy of a Moderately Frugal Life. Clements says the following,
I think that Clements is spot on about one thing and completely misses on the other half. It is true that the point of investing is to be profitable. However, I’d argue that when investing is profitable, it is extremely exciting! This is the Fourth Philosophy: Smart Investing is Exciting Investing
The Fourth Philosophy: Smart Investing is Exciting Investing
It is a simple principle, be a smart investor and give yourself the best shot at retiring how you want and when you want. The question becomes the following, what is “smart” investing?
Merriam-Webster defines smart as “showing intelligence or good judgement.” Therefore, a smart investor would be someone who shows good judgement about what to invest in and makes intelligent decisions based off of good evidence. We all know the girl who bought a bunch of stock in google/bitcoin/amazon who made a lot of money (or claimed they did)! However, we must recognize that this is unlikely to happen for us. The smart bet is not to place a lot of money on individual stocks and hope/pray that they skyrocket. The smart bet is to put money away every month into what we think has the best risk/reward. This usually means placing your money into the lowest cost, best index fund we can find that will get us to our goal. Our goal should not be to beat the market, but to simply match it. This is the surest way (I’d dare say the smart way) to achieve our financial goals.
The reason that this kind of “smart investing” is boring is because it makes money. Why do you think so many financial gurus (Jack Bogle, Warren Buffet, etc) recommend you to invest in low-cost index funds? It’s because they are your best bet to accomplish your goals.
Why Low-cost index funds?
There are two kinds of funds, index mutual funds and actively managed mutual funds. There are two major differences.
1) Index funds mirror a portion of the market (for example, the S&P 500) or the entire market (Vanguard’s Total Stock Market Index) whereas actively managed mutual funds are usually run by hedge fund managers who are trying to pick “the best” stocks and avoid the “bad ones” in order to beat the market. You pay the hedge fund manager to be exceptionally good at their job in hopes that they pick the best stocks.
2) I’ve already mentioned the second major difference in passing. You pay the hedge fund manager for their expertise.
Not all funds are created equal
If the information stopped there, you might think that a Hedge Fund sounds like a great idea! You simply pay someone who is supposed to be an expert at analyzing the market and picking the best stocks that you get ahead. Just like you’d pay a doctor for their expertise, you are paying the hedge fund manager for theirs. You have now found the secret for making lots of easy money, right? …. Unfortunately, this is very wrong. Here is why.
1) Hedge Fund Managers are historically very bad at picking the best stocks and outperforming the market. Buffet’s bet in the introduction is a great example of this. Complicating matters still, picking the 1 out of 20 funds that performs better than their respective market bench mark over a long time-frame can prove rather challenging! Actively managed funds have a 5% chance of doing that. It gets worse, though. Just because that hedge fund was in the 5% of funds that beat their respective bench mark over the past few years doesn’t mean that it will beat the benchmark in the next ten years.
2) Even if you pick the 5% of hedge funds that beat their bench mark and it even stayed better than the bench mark for the next ten years, it has to beat the bench mark by at least as much as the cost you are paying the hedge fund manager (and your financial advisor if you have one)!
How exactly is a hedge fund manager paid? This is where something called expense ratio’s come in. The typical expense ratio for an actively managed fund is 2%. So, in order for that fund to be “better” than the index fund you should have picked, it has to outperform it by almost 2%. [And if you are using a financial advisor, they are probably plugging away into these hedge funds so that the can get the commission, also known as a “load].
Note: The expense ratio for a good non-actively managed index fund is usually <0.1%, particularly at Vanguard and Fidelity. So, technically, the actively manged funds only have to outperform the index funds by 0.9-1.9%. Still, not likely to happen.
Why doesn’t everyone invest in low-cost index funds?
The most obvious answer is that humans will be human. It is much sexier to “pick the winner” so that you go around and tell everyone how you won out on the most recent hot cryptocurrency. In fact, my brother-in-law texted me multiple times over a week or so about his cryptocurrency investment that was doing so well despite the fact that he doesn’t invest in anything else of substance. This is the reason most people say that good investing is boring investing. However, I think making money with sound, researched, and disciplined decision making is extremely exciting!
The reason that The Fourth Philosophy is so important is that it encourages us to stick to the method that we know works and to recognize that the excitement involved is in the profits we know we are likely to make over the next 10, 20, or 30 years. Avoid trying to beat the market, because the odds are heavily stacked against you.
Smart investing looks like this:
1) Fully fund your company’s 403B/401K (18500 per year starting in 2018)
2) If married, fully fund your spouse’s 403B/401K
3) If either of you have a governmental 457, I would fully fund this, too. [Non-governmental 457’s are more complicated]
4) $5500 into a backdoor roth IRA for you (and your spouse) = $5500 ($11000, if married)
5) If you still have money left over then start investing in a taxable account until you are on target to obtain “your number” by the age you want to obtain it.
6) If you absolutely must invest in something fancy (collectables, precious metals, cryptocurrency, etc), do it AFTER you have accomplished 1-5 above.
What do you think? Is there any place for high volatility investments in your portfolio? At what point does it become okay to invest “more aggressively”? Does it ever?