In Part 1, we covered the history of the stock market and how it works. In Part 2, we’ll talk about how to use the stock market to reach your financial goals.
How can you use the stock market to build wealth and create financial independence?
That begins with understanding of mutual funds.
Mutual Funds and Professional Money Managers
Most investors don’t buy individual stocks, but instead they use mutual funds to meet their financial goals. A mutual fund typically uses money from many people to buy an assortment of stocks, bonds, or other assets.
A large mutual fund may pool the money from thousands of investors. A professional money manager will decide what assets to buy or sell, depending upon the type of fund. Most funds concentrate on a certain class of asset, such as large cap stocks, federal government bonds, technology stocks, or other asset classes. Chances are if you have a workplace retirement plan such as a 401(k) or a 403(b) that plan includes mutual funds as investment options.
When evaluating mutual funds, these are some of the key factors that should drive your decisions:
- What types of assets does the fund own?
- What are the goals of the fund, and how do those goals match yours?
- How aggressive, risky, or conservative is the fund, and does that match your risk tolerance?
- How does the fund fit your overall financial plan?
- What expenses does the fund charge? (Funds take a percentage of the money you invest as a fee; some charge additional fees as well)
- What is the track record of the fund and its professional managers?
There’s one more consideration: Should you buy an active fund or a passive fund? More on that in the next section.
Passive vs. Active Management
Mutual funds can be actively or passively managed. There’s a huge difference.
With actively managed funds, a fund manager or team of managers research, buy, and sell stocks based on their research, experience, and intuition. The portfolios of stocks that they own tend to vary often. They almost always have higher fees than passive funds to pay for their managers, researchers, and trading costs.
Passively managed funds buy based on an index. For example, there are many passive funds that own the 505 stocks in the S&P 500 index. Others may own all of the mid-cap stocks on the market, all of the top government bonds in the bond market, or some other asset class tied to an index. Those funds will perform in tandem with the index ion which they’re based. Typically their fees are much lower than active funds, because there’s no team of researchers or traders to support. Those fees can be less than 0.1% of the amount you invest. Because passively managed funds do very little trading, they also tend to be more tax efficient, resulting in lower capital gains taxes.
Those lower fees, also known as expense ratios, can mean a lot to investors.
The difference between, say, a passively managed fund with an expense ratio of 0.08% and an actively managed fund with an expense ratio of 0.76% might not sound like much, but over time the differences can be significant.
Say you invested $10,000 in a fund with an annual fee of 0.08% and $10,000 in a fund with an annual fee of 0.76%. Both funds return 5% annually for 10 years. The lower-cost fund would be worth about $16,165; the 0.76% fund would be worth about $15,150, or about $1,015 less. And the difference would only grow over time, with the lower-cost fund worth about $3,187 more after 20 years.
Keep in mind that in this case the actively managed fund would have to outperform the passively managed fund by 0.68% every year just to equal the passively managed fund’s returns. An actively managed fund with a higher expense ratio the equivalent of starting a race several steps behind competitors.
More importantly, over time only a minority of actively managed funds manage to outperform their passively managed peers. Depending upon the asset class, over 20-30 years less than 10-30% of all actively managed funds manage to outdo their relevant benchmark. In other words, the vast majority of actively managed funds that concentrate on large cap stocks don’t do as well as the S&P 500 index, and that’s true of other asset classes and indexes as well.
How to Invest in the Stock Market
There are four things to know about stock market investing.
First, investing in the stock market should be reserved for long-term financial goals, such as retirement or college, that are years in the future. The stock market is too volatile for short-term investing for most investors. If the plan is to save enough to buy a car or a house within a few years, find a high-yield savings account or high-yield CD.
The second is that investors who try to time the market generally don’t do well. Psychologically, many investors don’t want to invest when the market is dropping, and only want to pour money into the market when it rises. They often wind up buying when stocks are expensive, and selling when stocks are cheaper. This is the opposite of “buy low, sell high.” In fact, over the last 30 years, while the stock market has averaged about a 10% annual return, the average investor who tried to time the market has seen about a 4% average annual return.
The third is that, unless you’re buying or selling individual stocks every day, there’s little reason to check the value of your investments daily. Watching the gyrations of the stock market and your investments often leads to anxiety and uncertainty, as well as decisions you may come to regret. If you’ve chosen good mutual funds, let the market do what it does day-to-day and don’t worry about it. You probably wouldn’t check the value of your home every day, and your investments should be treated the same.
Most importantly, have a plan. Either on your own or with the help of a financial planner, analyze how much you’re investing, your goals, and your tolerance for risk. Then trust in your plan and let the market help you reach your financial goals.