Your Money_ The Missing Manual - J. D. Roth [131]
Think Long Term
Short-term returns aren't an accurate indicator of long-term performance. What a stock or fund did last year doesn't tell you much about what it'll do during the next decade.
Over the short term, index funds are, by definition, average (see Index funds). But a funny thing happens the longer you hold onto them: They begin to float to the top of the stack. That's because the "hot" funds don't stay hot year after year—they cool down. So while index funds are usually in the middle of the pack in any given one-year period, they shine over the long term.
During the recent stock market tumble, some folks shouted, "Look! Buy-and-hold investing is dead!" They took the stock market's decline as evidence that passive investing with index funds doesn't work. Well, it doesn't work if you sell after a fall, but if you hold onto your investments, you're fine—you haven't lost anything but time. In fact, many savvy investors viewed the market crash as a chance to buy—and hold onto—even more shares of their index funds.
Investing is a game of years and decades, not months. What your investments did this year is far less important than what they'll do over the next decade (or two, or three). Don't let one year panic you, and don't chase after the latest hot investments.
On The Money: The High Cost of Trading
Here's a dirty little secret: Wall Street makes money on activity; you make money on inactivity.
When you buy and sell securities, you have to pay somebody else to make those trades for you. And every time you pay them, you lose a little piece of your savings. This isn't a huge deal if you don't trade often, but if you buy and sell all the time, you're giving your money away.
For example, say it costs 1% each time you sell what you currently own and buy something new. If you do this once a month, you have to earn 12% more every year than the guy who sits there and does nothing. This example is an exaggeration, but studies show that speculators who trade often—usually because they're chasing the latest hot stock—tend to earn less than investors who take a long-term view.
If you want to get an idea of how much money the financial industry siphons from unwary investors, read James B. Stewart's Den of Thieves (Touchstone, 1992), a true-life account of the insider trading scandals of the 1980s that'll blow your mind.
Keep Costs Low
What's the easiest way to tell how well a mutual fund will do? Its past performance? The fund's manager? Nope. According to a 2002 study by Financial Research Corporation, the best way to predict a mutual fund's future performance is to compare its expense ratio (Mutual Funds) with other funds in the same class. The funds with the lowest fees tend to do better. (Remember, each mutual fund lists its expense ratio in its prospectus.)
Other experts agree. In his book Your Money and Your Brain, Jason Zweig notes, "Decades of rigorous research have proven that the single most critical factor in the future performance of a mutual fund is that small, relatively static number: its fees and expenses. Hot performance comes and goes, but expenses never go away." Zweig offers the following suggestions:
Don't buy a government bond fund with annual expenses over 0.75%.
Don't buy a blue-chip U.S. stock fund with annual expenses over 1.00%.
Don't buy a small-stock or high-yield bond fund with annual expenses over 1.25%.
Don't buy a foreign-stock fund with expenses over 1.50%.
You can keep things simple by sticking to index funds with expense ratios below 0.50% (or even better, below 0.25%).
And avoid buying a mutual fund with a load, or sales charge (basically, a commission). You already learned that actively managed funds have to overcome drag that index funds don't (Index funds); why would you make things even tougher by paying a 5% load, too? It doesn't matter whether the fund is front-loaded (you pay the commission when you buy the fund) or back-loaded (you pay