When I first started investing, I picked the stock and tried to time the market.
I failed miserably and lost over $20,000. I was confident to buy when the market is rising — and when I did, I entered at its almost highest point. And then I got scared and wanted to get my money back, so I sold and exited — at its low point. Everyone knows we have to “buy low, sell high”, but it is easier said than done. And betting on individual stocks really tests the nerves and self-confidence.
Therefore, I started to look for ways that do not require me to pick the stocks and do not need me to do the impossible — foresee the future and time the market. And I found index funds.
The importance of low cost
Warren Buffett publicly presented a challenge at the 2006 shareholders’ meeting: he is willing to use a $ 1 million bet to accept anyone’s choice of up to 10 hedge fund portfolios to compare performance against the US S & P 500 Index Fund and win $ 1 million from each other and donate it to their designated charity.
After the matter was made public, Ted Seides, the co-manager of the former investment company Protégé Partners, accepted the challenge and selected five hedge funds to challenge Buffett.
The bet officially ended on December 31, 2017.
The 10-year return rate of the index fund selected by Buffett was 94% in the past 10 years, the average annual return on investment was 8.5%.
On the other side, Saids chose a fund return of 24% and an average annual return on investment of only 2.96%.
The result of the game was obvious that Buffett used the index fund to win and won a significant fund for the charity he chose.
The reason why Buffett can win is “low cost”, because he chooses a low-cost index fund, which allows him to obtain a reasonable return on the stock market at a low cost.
As time passes by, the low cost gives him better returns.
Asset allocation
Most people think that picking the right stock is the most important thing. Others consider that the timing to buy and sell is equally important. Is this true?
When it comes to investment, everyone always cares about the timing of buying and selling and choosing the investment target, but Gary Brinson, a well-known investment scholar in the United States, found that asset allocation is the only key factor in affecting the rate of return.
Brinson dismantled the total return on investment to study which factors contributed the most to returns.
His study team observed the data of 91 large-scale retirement funds in the United States from 1974 to 1983.
They found that asset allocation determined 91.5% of the investment return.
Choice of investment target merely contributes to 4.6% of the return, and the timing of the purchase and sale only contributed 1.8%.
More thoughts…
The stock market has undergone considerable changes in the past half-century. It is becoming increasingly difficult to continue to beat the market. Index funds have, therefore, become a more sensible choice as it allows us to diversify. Index fund, simply put, is a fund that tracks index and the index reflects the collective price of a basket of stocks. Therefore, by investing in an index fund, we have access to a basket of stocks at a fraction of the price compared to if we want to buy 1 of each companies in the fund.
Higher returns on index investments (see above story about Warren Buffett’s bet)
One important benefit of index funds that set them apart from other active-managed funds is their low expenses ratio. The fees would eat into our return directly. Say if our investment originally generates 4% a year, with 1% fees, our investment only gives 3% return. That could make a cast difference when our investment amount accumulated to a significant lump sum. And you know how hard it is to make 1% more — compared to index fund which charges generally less than 0.1% fees (with better performance!), it becomes quite obvious which one to choose.
Index funds allows you to have better asset allocation. If your investment plan includes diversifying across equities (stocks) and bonds (and perhaps further diversifying across different regions across the globe), index funds can help you achieve that with ease. You do not have to read a thousand annual reports (like Warren Buffett) unless this is your hobby. You can simply pick the funds with your desired asset to come up with a portfolio that fits your investment goals and needs. As we now know that asset allocation determined 91.5% of the investment return, let’s not waste time on stock picking and instead spend more time with our loved ones!
Index funds avoids management risks and reduces the risk associated with replacing managers. Index funds do not need active managers (hence the low expenses ratio), and this feature also reduces the risk of poor management or unstable performance (as managers have emotions too and would not be immune from irrational decisions from time to time).
8. Warren Buffett recommends index funds (more than once!)
Note: this is not investment advice. I’m not a financial planning professional. Just sharing what is working for me as part of my investing strategy or what I have learnt on my investment journey. Please be reminded to do your own research and consider your own circumstances before making any financial decisions. You could also check with your financial professional to understand what would be best for your situation.
