Last year I read Snowball, the biography of Warren Buffet. While learning about Buffet I was reminded, that success rarely comes from luck, or divine gift. Rather, it is a combination of natural advantages, hard work, and sometimes, a total commitment to a goal at the expense of everything else in ones life.
The same applies to investing success - as defined by consistently outperforming the overall stock market. Few achieve this standard, and fewer do so over an extended period. Warren Buffet is one who has had long term success. He is smart, but he also worked harder than most in the business. As a young man he spent weekends studying business reports and company financials in the records room at Moody’s (a financial analysis company). He asked and reviewed information nobody requested. He went to visit companies on weekends and interviewed staff and management. During a college course on investing at Columbia he knew more about the text book examples than the author/professor of the text. He sacrificed home and family life. He was notoriously cheap. Success came with great sacrifice.
Most stock market investors don’t commit to this level of sacrifice. So what is one to do if one wants to (or should) invest in the stock market? My answer is to accept average by investing in the total market through index funds. What do I mean by index funds? An index is a pre-defined collection of stocks that are designed to represent a sector of the stock market or even the whole market. When you hear that the Dow Jones Index was up 8% you are hearing that if you owned all 30 of the Dow stocks, you would have earned an 8% return. The Dow is a group of stocks that meet the definition of being the 30 largest industrial stocks in the US. It is an index designed to gauge the US economy. The S&P 500 is the 500 largest stocks in the US. It is a measure of the total US stock market. There is even an index called the Wilshire 5000 which is the total US market.
Starting about 70 years ago, people started studying the performance of pension funds – who were the primary stock holders in the country. What the studies found was that these funds, managed by the best and brightest investing minds, did not consistently beat the average return on the US stock market. Why? Well, If you think about the return on the total market, it is simply the average return of all the investors making decisions on the value of all the stocks in the market. It is the collective wisdom of every investor – including all the Warren Buffets in the world. So, an investor needs to be consistently better than average by an amount that exceeds their investment fees in order to outperform the market. If the market return is 8% and an investor earns a return of 9% but has fees that are 2% a year, the net return is only 7%. The same holds true for mutual funds. Mutual funds rarely beat their respective index over extended periods of time. In fact, the most efficient portfolio an investor can hold, from a risk return standpoint, is the total market. No other portfolio gives an investor as much return for its given level of risk.
For these vary reasons, I recommend that the core of any stock portfolio be an investment portfolio that looks like the total market and is either total market index fund or a collection of index funds that together look like the total market.
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