First Thing’s First: The Why

Before we get to the nitty-gritty of “how” to invest, I want to take some time to discuss with you the “why”. More specifically, why you should independently invest, instead of relying on some Fund. I’m not saying funds are always bad, but simply that there is a better alternative.

Let me get something out of the way—I’m not talking to the majority of the population here. Most people want nothing to do with managing their own money. in certain situations, this plays to their advantage. Investments will pay out much better when there’s a reasonable amount of starting capital and commitment.

Making more money from your day job is the best initial investment you could make. If you’re not there yet, your efforts might be better allocated in that pursuit.

How do you know when you’re ready to start investing? You have a comfortable salary and are saving some of it. If that money is just lying around in a long term savings account, it could be earning you interest.

If this sounds a little subjective, it’s because it is. Need more help figuring this out? Read “The Psychology of Money” by Morgan Housel.

Now, assuming you’re making enough money and have consistent savings, maybe you are too afraid (or too lazy 🤷🏻) to manage your own investments. That’s understandable.

You’ll then have to pay for someone else to do it for you. A ‘professional!’

The problem is, how does one know if they’ve hired a good fund manager?

Finding a Fund

Hedge Funds, Mutual Funds and ETFs (Exchange-Traded Funds) are just some of the options you can choose from. They all work in slightly different ways but they do have one thing in common—they all charge fees. I mean, that makes sense since they are performing a service but, for the most part, those fees end up causing worse returns than the market. Some fees are flat out abusive - see the 2 and 20 hedge fund fees.

In some cases, funds charge performance fees even if they underperform the market. So you need to find one that beats the market by a significant amount to account for fees.

Assuming you find one who is not just actively trying to separate you from your wallet, you still don’t know if it’s worth its weight in salt.

And how would you know that? There is an ocean of funds everywhere and they all claim to be the bestest, safest, awesomest of all. How do you know which ones are actually telling you the truth?

I guess we have some work to do then, we’ll need to sift through the list of all available funds to find the one that will beat the market. Well, last year there were around 7,393 Mutual Funds and that’s not even counting Hedge Funds (3,841) and ETFs (1,809). And basically what they are all doing is trading stocks (or some related financial instrument).

With these many funds to choose from, one could assume there are tens of thousands of publicly listed stocks. Well, it might surprise you to know that, by the time of this writing, there are only 4,266 US stocks listed.

Just let that sink in. It is actually harder to sift through investment funds than it is sifting through stocks, just by sheer numbers alone. You might as well just pick individual stocks.

The easy way out

Yes, there is an easy way out of this. Ultimately, this is not what I think is best, but it is a good enough strategy, and that is to invest in Index Funds.

— But you just spend all this time bashing funds. How can you recommend a fund?

Well, Index Funds don’t beat the average, they ARE the average!

I know, I know, that’s an oversimplification. Index Funds are not really the average, but they try very hard to be—with some success.

Let’s say you just want to follow the market. After all, the market has returned 6.2% per year on average over the long term. That’s a pretty decent number.

Now, if you really wanted to get those returns, how would you go about doing it?

Well, one way you could do it is to buy a bag full of stocks, let’s say the biggest 500 companies in the US. Let’s think this through.

Why the biggest?

Because big companies tend to be at least somewhat successful. Never mind that a portion of them goes broke every year. Another portion of them grows over 50% every year too. We’re trying to average things out, remember? Big companies have shown a good amount of staying power. That’s basically why we are choosing the biggest.

Now, what makes a company big? I mean, who gets to decide which are the biggest 500? Well, why don’t we look at the stock market itself and just pick whichever companies have the biggest market value. This feels a little self-referential, and it also means we’re certainly overpaying for some companies (some expensive ones are bound to be in this grouping), but don’t worry about it.

Why 500?

Honestly, there is no reason, it’s an arbitrary number, it’s a “large enough number” that will make you “sufficiently” diversified. Peter Lynch would call it ‘deworsefied’.

How much should we buy of each company?

We could go at it in 2 ways, we could just divide our money equally amongst all the companies, or we could try to put more money on the bigger companies. Let’s try a combination of both, not equal, not completely related to how big they are, let’s go with a weighted average.

We’re basically trying to ride the idea that big companies are good companies, but also expose ourselves to the upside of smaller but growing companies.

Solved, all we need now is to have someone keep track of all that, buy and sell companies accordingly, and keep doing this forever. Sounds like boring work, but easy to do, it doesn’t take huge brains, therefore it should be cheap. Remember the fees? This fund should have low fees because it is so straightforward.

Congratulations!!! We’ve just created the SPY Index Fund (SPDR S&P 500 ETF Trust). This fund exists and you can buy it. It will do all that we have discussed, and it will give you exactly what we wanted, an average return.

Are there ways we could tweak this? Absolutely!

There are many flavors of Index Funds out there, each trying slightly different, simple strategies. What they have in common is that they’re all self-referential. They are not trying to choose the best stocks; they’re trying to follow some simple rules that broadly, mostly work.

You’ll get what most people get, and although that’s not horrible, it’s not great either.

I’d say we can do better. But it does take some work.