Richard Evans
Richard Evans

Evans, author of a new e-book, “The Smartest Way to Invest,” points out there are essentially 2 ways to invest:

  1. Select individual stocks and bonds, which requires trying to predict which ones will outperform the market. (Essentially, you’re trying to predict the future.)
  2. Buy entire markets (like the S&P 500) and don’t try to predict the future.

A wealth of data shows it’s extremely hard to pick individual stocks and bonds that will outperform the total market. Every year, S&P 500 and total market funds produce higher returns than the vast majority of actively managed mutual funds. (Actively managed funds employ fund managers who research, buy, and sell securities to try to beat a market benchmark.)

On the other hand, owning nearly all the stocks in an index means you’ll earn the same return as the index, minus very low fund costs. “A broad or total market index fund owns everything,” says Evans. “And when you own everything, you don’t run the risk of picking the wrong thing at the wrong time.”

Costs compound too

Keeping your financial costs as low as possible is crucial to your success. “Remember that costs compound just as your returns do. That fact can make a huge difference over the long term,” says Evans.

Since financial costs are usually listed as a percentage, some investors may see numbers like 1.25% and think a small number like that can’t have much of an impact. But, consider these 2 hypothetical investments:

 

Total investment costs

Present value

Annual return

Total value after 20 years

Investment A

1.25%

$100,000

6%

$252,976.76

Investment B

0.25%

$100,000

6%

$305,919.75

Note: This hypothetical example doesn’t represent the return on any particular investment, and the rate isn’t guaranteed.

According to an Investopedia.com calculator, Investment B would be worth almost $53,000 more than Investment A after 20 years, because the higher costs compound over time.

Index funds, by nature, tend to be the lowest-cost investments. Companies that offer these funds don’t pay high-priced fund managers to constantly research, buy, and sell securities. Plus, the funds themselves don’t incur many transaction costs—fund managers buy and sell securities only when the index changes.

4 principles to keep in mind

Because of their low costs and proven ability to outperform most actively managed funds, Evans believes broad-based index funds should be at the core of nearly every investor’s portfolio. His book outlines 4 simple principles every investor can follow to help achieve investment success:

  1. Buy index funds.
  2. Buy broad-based index funds.
  3. Invest globally.
  4. Buy and hold.

Broad-based domestic stock funds give you exposure to the whole U.S. stock market. These funds hold all the stocks in an index, so you have a complete selection of stock holdings. And because markets span the globe, Evans also recommends investing around one-third of your portfolio in broad-market international index funds. These 4 principles also apply to bonds as well as stocks.

His fourth principle—buy and hold—is often overlooked.

You could be your own worst enemy

Investing can be emotional. You’re putting your hard-earned money at risk, so it’s easy to feel helpless when markets go down. But investing is one place in life where it might pay not to take any action.

“Even smart people respond to sudden movements in the markets,” says Evans. “But, ultimately, this behavior is often destructive to your long-term results.”

In his book, Evans references a study by Dalbar, Inc., a research and advisory firm that studies investor behavior. The study showed that “every year … investors in both stocks and bonds earn far less than the funds or portfolios they’re invested in.”

Why? Investors, on average, panic and move money out of the market when there are sudden—and often sharp—downturns. And they invest again only after the markets have rebounded far beyond their low point. This behavior conflicts with common sense, because it means selling low and buying high.

That’s why it’s important to keep a long-term perspective. “If you don’t buy and hold, you just might buy and lose,” advises Evans.

Trust the data

Evans acknowledges that following his strategy may require people to change the way they invest. “And that’s not something to be taken lightly,” he concedes. “However, the data supporting index funds outperforming active management over the long run are clear and convincing.”

He also points out that investors can’t necessarily get around this fact by buying only past market-beaters.

In 2014, The New York Times published an article summarizing a revealing Dow Jones study. It showed that over a 5-year period, only 2 actively managed funds—out of 2,862—beat their benchmarks. And in the sixth year, none of the funds beat their benchmarks.

That doesn’t mean it’s impossible for actively managed funds to beat total market returns. But the data show the odds aren’t in your favor.

And don’t follow the money

Evans believes there’s a simple reason most people still invest their money in actively managed mutual funds. “It’s a deep-seated facet of human nature. People believe what they want to believe, no matter what the evidence may say.” 

“But if you invest for the long term based on my 4 principles, it’s very likely you’ll outperform the vast majority of actively managed funds.”

 

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Opinions expressed by Mr. Evans are not necessarily those of Vanguard.

Vanguard accepts no responsibility for content on third-party websites.