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Many of us read countless advices about investing, with a vast majority of them recommending low cost index funds for the individual investor. Some of the articles provide a better argument than others, while some don’t give a reason at all. This article illustrates what happened with one of my reader’s investment portfolio so we can judge for ourselves whether low cost index funds are for us.
MoneyNing,
Like you, I am in the west coast and when I get to the office, the US stock market has opened. Sometimes I check the performance of my stocks, and other times I do not (actually, I check it all the time). When I did check it this morning, I noticed that the money in my taxable account went down by 12%. I looked into the details and realized what has happened. One of my stocks Wavecom (WVCM) just reported earnings and the stock went down 20%. Since I had much money in this stock, I was hurt bad. Really bad. Panicking, I sold WVCM along with Apple (AAPL) because I was afraid Apple was going to report bad earnings too. I’m really pissed off right now because I checked after hours and Apple is up more than 10% since sold it. I realized I was being dumb and really want to see if you can recommend some low cost index funds for me to own since I am clearly not cut out for stock picking.
Regards,
Money Ning Reader
His story is all so familiar. I remember I have made similar mistakes in the stock market because I too panicked when a stock did not go the way I thought it would. In reality, I was always selling low and buying high because when stocks go down, I will sell and then when they go up, I will buy.
When stocks go down significantly, some of us almost get this sickening feeling in our stomach. Sure, any individual stock could go up significantly and boost your portfolio, but the risk is also the highest.
Some people who pick individual stocks do not know much about the stocks. In essence, many of these people are treating the stock market as a casino. Also, many of us do not have the tolerance to properly manage the emotional rollercoaster of individual stock prices going up or down. We end up buying high, and selling low because the volatility of stock prices truly tests our greed and fear.
Everyone that has individual stocks in their portfolio should examine their tolerance not when times are good (when stock prices are soaring) but when times are bad (the day the price drop significantly). Only in adversity can we truly determine our risk tolerance since we actually need to react to real life circumstances.
Low cost index funds on the other hand are much less volatile. No one will become rich overnight, but it is a much calmer style to investing in equities. It gives us the comfort that our portfolio would not get crushed if something horrible happens to any particular company (e.g. Enron).
I want to thank the reader for allowing me to share this story with everyone and to give some comments on the story. This allows all of us to learn from this experience and I applaud his openness and honesty as it is often tough to do.
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I agree completely. Look at the market again today. If you are in it for the long term, there’s no reason to pick stocks since you never know how badly you will be hit.
This is a good story and low cost index fund is definitely a good way for beginners to get into the market.
However, I would encourage everyone to at least use a small portion of their porfolio to learn more investing. If you are not up for it, create fake portfolios, track them, and see how they would perform.
I recently did an analysis on how anything other than low fee funds can really destroy your wealth. For example, a fund with 2% expense ratio can take away almost half of your investment in 30 years. Personally, I am starting to transition from mutual funds to ETFs. This should save me a lot of expense fees in the long term.
Pinyo - Yeah seems like those management fees really eat up your portfolio. Imagine when your mutual fund goes down 5% that year and the management fee adds another 2%!
I also heard that mutual funds can have captial gains even if they have a down year! I’m not sure how that happens but I just remember something like this. Maybe someone who knows more can share their take on this.
Calvin: I believe whether someone should pick individual stocks or not will depend on how emotionally detached he can be with the market plus his knowledge of the stock and market (which can be learned).
Mutual funds are required to pay out distributions if they sell a security at a profit no matter what happens to the overall fund performance. That’s why you are getting this. I probably should do a full write up on this just so everyone is clear. Stay tuned.
Pinyo: Expense ratios are another one of those things that kill portfolio performances. Thanks for bringing that up.
Calvin - yeah, it hurts when the fund goes down and give you a distribution. It hurts to buy a fund late in the year, get the distribution, and essentially pay other people’s capital gain taxes. A fund can distribute even when it looses money because by law, funds have to distribute any taxable gains from investing to shareholders each year. So if the fund sell some of its winning stocks, you get stuck with the distribution. For example, my $4,000 holding in HFCGX distributed $600 last year. Luckily, it was in my IRA so I didn’t have to pay tax.
MN - no problem. thank you.
I think one problem with mutual funds is that they distribute capital gains, but they do not distribute investment losses! That means if they sell a position at a loss, the fund takes the income offset for itself, they do not distribute it to the fund holders to lower their taxes. When they sell a position at a gain, they distribute this gain so the fund holders must pay the usually short-term capital gains! It does not seem fair, and it is why I do not hold mutual funds outside my 401k!
Even in a 401k index funds are a good idea. Seems many mutual fund managers are too smart for their own good, and waste a lot of money in transactions when buy-and-hold is usually the most effective equity strategy over the long term.
There is an excellent book about this called by David Swenson. Does anyone remember the name?
Carl: I think the book is called Unconventional Success: A Fundamental Approach to Personal Investment (I just did a search on Google).
Actually I’m starting to think more and more that low cost index funds are the way to go even if I can pick individual stocks. Yes they are quite boring, but it is what I need since I don’t want to manage so much money since
1) I’m not extremely good at it.
2) I don’t have time to handle the research needed along with the blog, my job and my family
3) read 1 and 2 a few more times!!!
Pinyo: Geez $600 dollars distribution for $4000?!? That’s a pretty big percentage. I guess you are buying those actively managed mutual funds huh?
Carl: Umm. I wonder what’s the logic behind this since I assumed someone has thought about this scenario and deemed that it is fair to only tax gain distributions.
All: Thanks guys for the explanations!
Calvin: I was surprised too since it was a low turnover fund. I have since switched to ETFs.
Pinyo: I think ETFs are much better than mutual funds in general because they trade like a stock which means they are much more flexible (cheaper, can be sold immediately if need be etc etc).
I agree. There is one situation where mutual fund is better, that is if you have small amount of money to add regularly. With no load fund, you incur no trading expense. However, you will get to the point where you have enough money in the fund to make an equivalent ETF more attractive.
Pinyo: That’s true but you can always use something like Zecco if you are worried about fees.
How do you determine a low cost index fund? What parameters/aspects do you look at to determine that?
thanks
smokey888×2: Check out tomorrow’s article for some ideas!