The 5th Step to Financial Freedom – Invest in Stock and Bond Index Funds

Posted on February 18, 2016

Investing in stock and bond mutual funds (not individual stocks and bonds) is the simple way to get higher investment returns than more conservative investments like bank accounts, money market funds, or certificates of deposit (CDs).  By owning stock funds, you own businesses, and the long-term return of these businesses is what will increase your investments and net worth.  In addition, it is the only way you can invest and stay ahead of inflation.

If you put your money in a savings account that earns 1% (the highest rate you can get nowadays) but inflation is 3% that year, you just lost 2% of purchasing power.  With a historical inflation rate of approximately 3%, you can’t even keep up with inflation and break even without taking some risk and earning a return of at least 3%.  The long-term return of the stock market is approximately 9.5% per year.  Adjusting for 3% inflation, $1 of purchasing power invested grows to: (Bogle, 2007)

• $1.88 in 10 years
• $3.52 in 20 years
• $6.61 in 30 years
• $12.42 in 40 years
• $23.31 in 50 years

When it comes to selecting stock and bond mutual funds, you will have to take a look at the investments offered by your financial institutions and select from that menu.  The principles to guide you should be:

1. Favor index funds over actively managed funds. An index fund is a fund whose goal is to mirror the performance and composition of a standard basket of investments, like the Standard & Poor’s 500 (S&P 500) Index. An actively managed fund means that a fund manager is buying/selling investments as they see fit in an effort to beat “the market” or a comparable index.  We’re investing for the long-term, and over this time frame almost no actively managed funds will beat their index.  In addition, because past performance does not predict future performance, there is no way to predict which of these very few active funds will beat their index.  Index funds are low cost, tax efficient, simple, and give you a higher return.  Don’t try to beat the market, join it by investing in index funds.

2. Favor mutual funds with low expense ratios. What is an expense ratio? An expense ratio is the percentage of a fund’s assets that is used for expenses.  In other words, if you invest in a mutual fund with a 1% expense ratio and that fund makes 10% in 2016, you’ll only get a 9% return on your investment because 1% goes to pay expenses.  The less of your return you use to pay expenses, the more you get to keep.

What is an average expense ratio?  An average stock mutual fund has an expense ratio of about 1%, but the expense ratios for mutual funds that are similar in their composition can vary wildly.  For example, if you look at a list of S&P 500 index funds offered by investment companies, you’d find expense ratios as low as 0.05% (Vanguard S&P 500 Index Fund Admiral Shares, VFIAX) and as high as 0.6% (Great-West S&P 500 Index, MXVIX).  While 0.55% does not seem like that large of a difference, keep in mind that costs last forever and that small differences compounded over years will cost you a lot of money.

What is an average expense ratio?  An average stock mutual fund has an expense ratio of about 1%, but the expense ratios for mutual funds that are similar in their composition can vary wildly.  For example, if you look at a list of S&P 500 index funds offered by investment companies, you’d find expense ratios as low as 0.05% (Vanguard S&P 500 Index Fund Admiral Shares, VFIAX) and as high as 0.6% (Great-West S&P 500 Index, MXVIX).  While 0.55% does not seem like that large of a difference, keep in mind that costs last forever and that small differences compounded over years will cost you a lot of money.

Let’s pretend that when you are 25 years old your grandparents give you $10,000 to invest in a S&P 500 index fund for 50 years, during which you earn a 9.5% return.  If you invested in the Great-West index fund with the 0.6% expense ratio, you would have $683,000.  If you invested in the Vanguard index fund with the 0.05% expense ratio, you would have $902,000.  That 0.55% difference in the expense ratios cost you $219,000!  Small differences in expenses can make huge differences in long-term investment returns, so you need to pay attention to the expense ratios of your investments.

The expense ratio should be less than 1%, preferably less than 0.5%, and optimally less than 0.25%.  If you want to keep this really easy, just invest in the index funds offered by the Thrift Savings Plan (TSP) or Vanguard as they all meet these criteria.

3. As previously discussed, in order to beat inflation over the long haul, you’ll need to invest some of your portfolio in stock index funds. Investing in stock and bond funds is not for the weak hearted because you can lose money. Over the long term, though, assuming higher risk leads to a higher return.  As you progress toward retirement, you will decrease your investment risk by decreasing the amount you invest in stocks and increasing the amount you invest in bonds.

The optimal asset allocation of investments depends on your age, financial situation, risk tolerance, and how soon you will need to utilize the investment.  If you are young, you have longer to ride out the inevitable market swings.  The more financially secure you are, the better you can deal with the swings as well.  Your asset allocation should also reflect the amount of risk tolerance you have.  My opinion is that you should take as much risk as you can tolerate.  If you can’t sleep at night because you are worried about your investments, it is time to dial down the risk, but you should take as much risk as you can up to that point.  More risk yields a higher return over the long-term.

A number of guidelines for asset allocation from trusted references are discussed below:

Malkiel & Ellis suggest this as a conservative asset allocation:

They also suggest a more aggressive asset allocation, which is my personal favorite due to the protection offered by our inflation adjusted military pension (assuming you stay in for 20 years):

John Bogle, the founder of Vanguard, suggests as a conservative asset allocation rule that your percentage of assets in bonds should equal your age. In other words, at age 30 you should have 70% in stocks and 30% in bonds.  A more aggressive version is to subtract 10 from your age, so at age 30 you’d have 80% in stocks and 20% in bonds.

One very easy way to let someone else make this decision for you is to pick target retirement funds as your investments.  Many investment companies offer these, including the TSP and Vanguard.  You just pick the approximate year you plan to retire or start using the money, that year will likely be in the name of the fund (Target Retirement 2035, for example), and invest in that fund.  Your investments will gradually get more conservative as you age without any action on your part.  Just make sure that the target date funds you use are composed of index funds with low expense ratios (again, using the TSP or Vanguard funds makes this a no-brainer).  A target retirement fund composed of actively managed funds with expense ratios greater than 1% is a target retirement fund to avoid.

When investing you need to keep this truth in mind…the market will go down, and when it does you need to resist the temptation to sell investments or stop investing.  The best time to buy an investment is when it is cheap and you can get the best deal.  When the market recovers, which it will, you will reap the rewards.  Focus on the long-term and just keep investing.

Every time you get a raise, bonus, or income tax refund, use it to increase the amount you invest for retirement.  You should save at least 15% of your gross or pre-tax income for retirement, but if you want to be rich or retire early you’ll need to save 20-30%.  If you find it difficult to save, set up an automatic investment plan so that the money is automatically removed from your pay and you never get a chance to spend it.  The TSP makes an automatic investment plan easy to implement.

REFERENCES

Bogle, J. C. (2007). The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Hoboken, NJ: John Wiley & Sons, Inc.

Malkiel, B., & Ellis, C. (2013). The Elements of Investing: Easy Lessons for Every Investor. Hoboken, New Jersy: John Wiley & Sons, Inc.