When many of us think of investing, our thoughts immediately jump to the idea of picking stocks. The hope is to find the “hot tip” or get in at the “right time” in order to make a lot of money in a short period. We talk about investing as though it's the same as stock trading when it's not.
William Bernstein, Ph.D., known for his books “The Four Pillars of Investing,” “The Intelligent Asset Allocator,” and his latest book “If You Can — How Millennials Can Get Rich Slowly,” among others, says that for most people the best way to invest is to leave the idea of stock trading behind.
Why You Can't Win at Stock Trading
“You have to start from the premise that, as an ordinary investor, as you buy or sell a stock or bond, there is someone on the other side of the trade,” Bernstein says. “Odds are good that the person on the other side has an I.Q. of 160 and has better access to information and systems than you do. It's like playing tennis with someone you can't see, and that person is Venus Williams.”
When you engage in stock trading, there are winners and there are losers. While you might get lucky on occasion, the reality is that, over time, the regular person is likely to lose out since he or she can't match the advantages a professional stock trader has.
“Your best option is to not trade,” Bernstein says. “Instead, you buy and hold the market through indexing.”
When you index, you aren't trading against the person on the other side of the transaction, trying to see who is going to ultimately come out ahead. Instead, you are investing in the market — or a portion of the market — as a whole. You “win” over time as market performance overall improves.
A market indexing strategy requires that you invest your money and leave it in the market for an extended period of time. Indexing works especially well with dollar-cost averaging, in which you invest a set amount of money each month, buying as many shares of an index fund as possible. Over time, your portfolio grows as you continue to purchase and as the market gains in value.
Indexing and Asset Allocation
“The best way for the average investor to get in the market is to do so through a company that offers index products cheaply,” says Bernstein. He points out that many people already invest through employer-sponsored retirement plans.
For those who don't have access to these plans, or who want to move beyond their retirement plan offerings, Bernstein recommends opening an account at a broker like Fidelity, Vanguard or Schwab. “All of these companies offer low-cost index funds and index ETFs, and can provide you with the ability to invest,” he says.
Now that you have an account, it's time to decide how to invest your money. Bernstein favors a three-fund (index mutual fund or index ETF) approach to asset allocation:
- Exposure to the entire U.S. stock market
- An all-world fund with exposure to stocks outside the United States
- A bond fund (U.S. Treasuries can be a good choice, but there are other bond funds as well)
According to Bernstein, this three-fund approach offers you the ability to diversify geographically as well as according to asset class.
Bernstein says that how you allocate your assets among these three funds depends on your level of risk. A younger person might put more of his or her investment money into stocks while a retiree would favor bonds.
If you don't want to worry about allocating assets across three different funds, Bernstein even has a solution for that. He says that many employer retirement plans include targeted retirement mutual funds. These funds are set up with a specific retirement year in mind.
The fund manager automatically adjusts asset allocation according to risk over time. Bernstein does have a caveat for the targeted retirement fund, however: “I would only trust Vanguard with a targeted retirement fund,” he says. “The rest have allocations that are very, very aggressive and I don't trust them.”
“Most people are going to start investing with a 401(k) plan,” Bernstein says, “and that's probably the smartest thing for the average person to do.” Once you learn a little bit more about investing and indexing, it can make sense to branch out a little bit and open an account elsewhere (especially if your company 401(k) options aren't very good), but don't tie up your assets with stock trading.
“Stock trading for most people is a losing proposition,” Bernstein continues. “If you want to win for the long-term, you're better off investing in the market and taking part in gains that are all but certain.”