Would like to thoroughly understand investment, then forget about it till age 50.

September 19, 2009 9:14 PM

Does the backlash against the Efficient Market Hypothesis have another answer for my lazy-investing needs?

So, reading about a 'random walk through Wall Street', etc., I was somewhat convinced, and then the little bit of information that (expert-in-not-much) Tim Ferriss posted from Warren Buffett (invest in a low-cost S&P Index fund) continued to push me in that direction. And, sure, I've put a very relatively small amount of money into an index fund since, but now I'm rethinking whether it makes sense to invest in something else.

Basically, statistically, do mutual funds or any other form of investment, outperform, on average, index funds, whether in a general sense or if you narrow them down to a known property like MorningStar ratings.

Here are some particulars, although they barely pertain to my question. If you've got some sweet investment advice (ha, please no penny stocks), then throw it at me; otherwise I'm really just interested in the 'going thought' amongst casual investors like myself:

- I've got ~$1,000 a month to invest. This is the delta between post-tax income and living costs
- I've got a whole lot in cash reserves to throw at other things gradually. Allocation is currently 90% cash, 8% mutual, %2 index. I know, insane, but, hey, it worked in this whole recession thing.
- No dependents, 22 years old
- No immediate need for returns, won't be in home-buying mode or anything like that (car either) for a while (~8 years?)
- Okay with risk but not flailing. Big fan of science.

posted by anonymous to work & money (14 comments total)

If you buy a lot of options betting on financial instruments going both up and down, you are essentially betting that the market is overly confident in it's predictions, against it's efficiency. You aren't betting on it moving in a particular direction, only moving in an unanticipated way. If you're wrong you slowly lose money for the options you're buying - but you could make a great deal of money during some unexpected event. Nassim Taleb did this.
posted by phrontist at 9:42 PM on September 19

At an absolute minimum, you need to start putting a good chunk of your "cash" into high-yield savings accounts, CDs, low-risk bonds, and similar instruments. It doesn't sound like the loss in liquidity will be a real problem for you (and tricks like CD ladders can help you maintain access to your money when you need it). While you can certainly make far more money with equities, and you should be doing so, moving your cash investments into something that will at least give you some reasonable return is an easy low-risk move you should be taking too. Traditional checkings/savings accounts are very much not a good way to handle significant cash reserves as they earn virtually nothing.

bankrate.com can be helpful in comparing rates for various savings products.

Remember too that bonds and bond funds can offer a middle ground in the risk-reward curve between cash and stocks and may offer tax advantages if you're investing in government bonds.
posted by zachlipton at 10:13 PM on September 19

(I'd also like to be clear that I'm not reccomending you do what he did, it's just what came to mind when talking about investment strategies that assume an inefficient market)
posted by phrontist at 10:23 PM on September 19

Index funds are great and usually out-perform mutual funds over the long run. Obviously, some mutual funds are better, but that could be a temporal issue. Unless you're ready to spend a lot of time in research and possibly still get it wrong, stick with an index fund.

Also, if you're American, I assume you are putting this in an Roth IRA, right?
posted by Pants! at 10:44 PM on September 19

See Adaptive Market Hypothesis
posted by jchaw at 11:16 PM on September 19 [1 favorite has favorites]

I would avoid options if i were 22 and did not want to spend _lots_ of time thinking about greek letters.

If your time horizon is really 28 years, you're basically safe buying anything; Avoid mutual funds unless you know and like the manager and their style. Index funds will likely perform better when you consider costs. Just try to diversify a little; find stuff that does not correlate much to the dow and the s&p.

FYI, some african stock market indexes had double digits % growth while "the market" lost more than half its value. (Ghana)

Again, if your time horizon is 28 yrs, even real estate looks good now..
posted by 3mendo at 12:55 AM on September 20

PS: check this link for a list of available ETFs that you can use to diversify into different asset classes
posted by 3mendo at 12:57 AM on September 20

(i doubt markets are efficent. I am entirely sure fund managers aren't.)
posted by 3mendo at 1:05 AM on September 20

3mendo- exactly. Markets ARE efficient in the long run. Eventually, things trickle up and down to an accurate price. But yes, in the short term, they are wildly inefficient- that's how we make money on them. Trade on emotion, invest on fundamentals.
posted by gjc at 4:06 AM on September 20

The benefits of index fund investing don't depend on the efficient market hypothesis being correct. Because the fees associated with index funds are so much cheaper than than with mutual funds, you can come out even or ahead even if the nonindexed mutual funds perform a little better.

Morningstar ratings are based on past performance, and past performance has nothing to do with future performance. Think of someone who sends an investment newsletter out, and half of his clients are told, "GM will go up" and half are told, "GM will go down." GM goes down, and the next time the guy sends out the newsletter, he only sends it to people he made the right prediction to. By the time he's made 8 predictions, he's got some small fraction of his original clients who think he's a genius. But it's all random.Morningstar is similar: the highly rated funds don't necessarily have smart managers, they have managers who got lucky, and there's no reason to imagine they'll be lucky in the future. (Go back 5 or 10 years and look at Morningstar highly-rated funds then, and see how they've done since.)

Read a book on asset allocation, because it turns out that it's possible to improve your performance without taking on higher risks by diversifying your index funds throughout the market. You want to have a bond fund, a small-cap value index, a large-cap index, etc.
posted by Jeanne at 4:17 AM on September 20 [1 favorite has favorites]

Index funds beet a majority of managed funds (see here). How do you pick the one that will actually do better than the market?

I don't think you can, I don't think I can.

You might want a fee based financial advisor. I'm not your financial advisor, if it were me. If your savings rate keeps up even without interest you'll have $100,000 by the time you are 30. If you want to buy a house or condo in a big costal city, this is enough for a down payment if you want to live in the midwest, you can almost a whole house for that.

If you will need house money keep some cash at 30. If you are looking to put together money for retirement put it in an Roth-IRA or 401k, I'm a big fan of target retirement date funds. Just figure out your house and car needs in 8 years, and throw the rest in retirement savings. Roth's work well because you can withdraw the principle.

You sound a lot like me at 26, I'm now 30 and married. If you save at the rate you are going and do not try anything risky, it really won't matter too much. With 70-120 in savings by the time you are 30 you'll be doing just fine.

So the main thing is make sure you keep up the savings. Kudos to you for your savings ability.
posted by akabobo at 8:20 AM on September 20

Unless you really want to spend the time to track the portfolio managers of your mutual funds, the computed risk measures, the performance, etc., I would dump them and go with an ETF or index fund. Most actively managed funds do not outperform their benchmark and you would have to invest the time to vet your funds and their managers one by one. Be careful of ETF and index fund products though, there's a lot of them on the market now and the MER on some are almost as bad as mutual funds.

If a friend asked me the same question, I would recommend this:

• Do some research and reading on the financial blogs and forums to find out why certain ETF and index funds are more popular than others with DIYers, learn what asset allocation is
• Build your own target allocation based on your time horizon (you expect to withdraw a certain amount for a downpayment some time in the future, will you withdraw everything or only just what you need?)
• Find low-cost funds that match your allocation targets and investment goals
• Save that $1000 per month in a high-yeild savings account until you have enough to buy more units in your funds and be consistent about this, sticking to your schedule through both ups and downs of the market
• Rebalance your portfolio every year (or even less frequently) to match your asset allocations

But you are not my friend, I don't know you, etc., etc. Finally, I'm not a big fan of lifecycle funds (e.g. Retirement 2040 Fund) due to their high MERs but the idea itself ain't bad, especially if you really want the close your eyes and open them again in thirty years approach. You might want to consider them if you are comfortable with their trade-offs.
posted by tksh at 9:28 AM on September 20

I think you know this already, but for the record: "mutual funds" and "index funds" are not distinct categories, either way you are buying a basket of stocks, bonds, etc. The key difference is whether the fund is actively-managed or passively follows an index. The overwhelming majority of active funds fail to beat the market (or their target benchmark, whatever it might be) on a long-term basis, and what are the odds that you'll pick one of the winners in advance?

Thus, you should aim to match the market while losing as little money as possible to fees (and taxes, but that's another topic). Index funds offer a low-cost way to purchase a diversified portfolio of investments at extremely low fees (by tracking an index instead of constantly buying and selling shares, they can reduce trading costs). ETFs that track an index are good too, although you pay broker fees to buy/sell them so for monthly investments you may do better with index funds.

I'd suggest you do a bit of reading on asset allocation (choosing the relative amounts of stocks, bonds, cash, etc based on your needs and risk tolerance). The Bogleheads forums/wiki are an incredible resource (named after Jack Bogle, founder of low-cost index fund family Vanguard). Good luck!
posted by Fin Azvandi at 1:14 PM on September 20

seconding vanguard for index funds -- always read the prospectus, especially for ETFs. (some are best suited to people who trade frequently, and not once a month)
posted by 3mendo at 1:38 PM on September 20