By Melissa Sotudeh, CFP®
This fall I moved my daughter back to college for her sophomore year. Of course, my husband and I dispensed a few pieces of advice:
“The career center has a new website and a new director; you should go check it out.”
“What organizations are you planning to join?”
“Do you have a balance of networking opportunities with faculty, alumni, and other students?”
Not one time did I say, “Be sure to study and go to class.” This was not because my child is an angel, but because that is just expected. That is the average expectation. In the financial world, there are also certain basics that need to be in place before you can leap from average to above-average.
But a lot of investors are confused about how to do this.
How to Be Average
After I came home from helping my daughter with the college move, by chance my son sent me a Freakonomics podcast that covered exactly this topic. Investors want to be above average, so shouldn’t they try to beat the market averages with active management? Well, we wouldn’t recommend it. Active management has very high costs, and investors are paying for a skill no advisor or fund manager can promise to deliver, as shown by academic research.
Kenneth French and Eugene Fama are two highly respected researchers (Fama has won the Nobel Prize) who have collaborated over the years on studies related to efficient market theory, which, in Fama’s words, basically states that “since prices [of investments] reflect all available information, there’s no way to beat the market.” In fact, they found that only 2-3% of active managers had enough consistent outperformance to justify their fee.
So should investors simply settle for “being average”? Well, paradoxically, using an index strategy that might be thought of as “average” actually puts you ahead of the majority of investors—especially those overpaying for strategies that do not work consistently over the long term.
Being Passive Doesn’t Mean Doing Nothing
“You get what you don’t pay for.”—John Bogle, founder of Vanguard
There are many low- cost ways to participate in the markets, and a major one is an index fund-based strategy because they are so inexpensive, yet allow you to benefit from market movement in a diversified way. Essentially, you get the average of all the ups and downs of the index. It has taken a long time for this strategy to catch on, perhaps because this strategy is also called “passive.” Who wants to be passive? Surely being active is better. Well, that’s certainly what those who get paid to trade would like you to think.
When John Bogle created the first index fund, he was the laughingstock of Wall Street. One brokerage firm even published a poster of Uncle Sam with the tagline “Stamp Out Index Funds.”
“The argument is, ‘In America, we don’t settle for average. We’re all above average.’ But, of course, we’re not all above average. But basically, the poster was put out by a brokerage firm. The thing about the index fund — no sales loads, no portfolio turnover. You don’t buy and sell every day like these active managers do. It’s Wall Street’s nightmare and it still is!”—John Bogle
Can an investor be above average without increasing risk? The answer is yes. You can add to your return in many ways that are within your control.
How to be Above Average
Just as my daughter takes going to class and completing assignments as the minimum needed to be average, investors need to know the difference between what is a “given” and what will optimize the path toward their goals. Some of the basics include not living beyond your means, having sufficient cash reserves (savings in the bank), contributing to your tax-deferred and taxable investment accounts, and progressing in your career.
But in order to become above average and truly grow your net worth, there are several steps one can take:
- Keep costs low. You get what you don’t pay for when it comes to investing—because it stays in your pocket to grow and compound over time. Naturally, if you have two identical funds, and one has higher expenses, the one with lower expenses will outperform. This is why we offer our clients Institutional level shares for index funds and ETFs. Institutional shares have a lower cost than the funds available to individual investors (retail shares), but they are inaccessible to most investors due to their high minimums. This is an economy of scale we are glad to offer to our clients!
- Keep tax-efficiency in mind. Related to keeping costs low, your portfolio manager and CPA should work to find a strategy that does not result in unnecessary taxes.
- Be diversified. A diversified strategy lowers risk because you are not taking huge bets on any particular stock or asset class. The strategy at Halpern Financial uses diversified mutual funds and ETFs to smooth out volatility of the overall portfolio. Emerging market stocks may do well one quarter, while large-cap stocks may lag behind. The idea is that when one area zigs, the other zags.
- Control behavior. Warren Buffett has some very wise advice: “You only have to do a very few things right in your life as long as you don’t do too many things wrong.” Stay disciplined in following your financial plan and try not to get distracted from your long-term goals.
- Prioritize goals and find a system to achieve them. Following a system is much more effective than relying on sheer willpower to achieve your goals. Rather than putting temptation in your hands to overspend, if you have a particular goal you are saving for, automate your savings.
Note that it does not entail taking a gamble, or being reactive to short-term events. Being above average does not need to entail taking on above-average risk. There are so many ways to accelerate your pace toward your goals!
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Halpern Financial, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Halpern Financial, Inc.. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Halpern Financial, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Halpern Financial, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.