Summary: Morningstar admits that low expense ratios can better predict a fund's future performance than their own star ratings.
Stocks have always outperformed bonds in any 20 year period, growing on average 7% a year with periods of huge decline.
What is a Stock?
Stock is a claim to the ownership and rights to the value of a company. You buy shares of company stock with the expectation that its value (price) will increase so you can sell your shares for more than you bought it for.
What is a Stock Fund?
A package of many stocks, sometimes hundreds. Stock funds are either passively managed or actively managed. An index fund is a passively-managed fund that is tracked to an index such as the S&P500. Almost no actively managed funds outperform index funds in the long run due to their higher expense-ratios.
Buy and Hold!
If you hold a shares for more than a year, any capital gains will be taxed at 15% when you sell it. Capital gains on your stocks are only taxed when sold (realized), so be sure to have a good reason before you make a sale, even for shares you've owned for over a year.
Which Stocks do I buy?
The data shows that professional investing firms are no more successful than random chance at picking which stocks are winners in the long run. After fees, their returns underperform the market by 0.8% on average.
Guess what a financial management firm's overhead costs are.
I see two important conclusions to be drawn from this evidence:
1. Hiring someone to manage your investments will not improve your returns, however it may save you time.
2. If the average math geek who's spent thousands of hours studying this stuff can't pick stock winners consistently, neither can you.
2a. Don't squander your time trying.
Thus, we should invest in stock funds, not individual stocks.
But how do you know which funds will grow? Isn't this strategy the same hubris but on a different scale?
The intuitive thing is to look at a fund's past performance. This makes sense in sports and many other parts of life, but not in investing. A fund's past performance gives you no information and should be ignored.
Stock analysis giant Morningstar's Russ Kinnel published an infamous report which showed that expense ratios predict future performance better than anything else- including Morningstar themselves. The conclusion supports the evidence of fund managers' failure to beat the market in the long run, and that in-depth analysis is a waste of time.
Okay, so I should buy the cheapest stock funds. How do I do that?
Open an account at a brokerage and ignore anything with an expense ratio above 0.3% (I made this number up arbitrarily. All of my holdings have ERs > .2%.)
Which brokerage should I choose?
Now that we have covered the three main asset classes (I will not discuss commodities and real estate- such assets are too speculative/volatile/tax-inefficient for my taste), we can start investing.
In the next article, we will begin investing in both stocks and bonds using a beginner-friendly brokerage.