This is the first of three articles in which I will show how just about any investor can achieve outstanding long-term returns using readily available low-cost products.
This time, I describe the three most important building blocks of a superior portfolio. In the second article, I describe some of the limitations and challenges of one of those building blocks, the target-date retirement fund. In the third, I outline a simple strategy that overcomes the limitations of target-date funds and is likely to offer terrific long-term performance.
By the end of that third article, you will have a winning strategy, and you’ll know the tools to help you put that strategy into action.
The three building blocks are the mutual fund, the index fund, and the target-date retirement fund. These products allow ordinary folks like you and me to be treated almost the same as wealthy investors. Used properly, they can give investors returns that are in the top echelons.
I’m not saying that the following applies to you, naturally, but these three products mean that even the most ignorant, the most uninterested, the most naïve investor can get fair and fairly priced professional treatment from Wall Street.
It wasn’t always that way.
Before the mutual fund was invented (The first was the Massachusetts Investors Trust, started in 1924), the investment world was structured for the benefit of wealthy individuals and other entities who had lots of resources — and for the benefit of the trust departments of banks and old-school firms that charged fees and commissions to buy and sell individual stocks and bonds.
Seeking an efficient way to help the children and other family members of their wealthy clients, some of these banks and investment firms created what became the mutual fund structure in order to pool money and share expenses and professional management.
The idea eventually caught on enough that such funds were made available to the public, and the mutual fund as we know it today was born.
The advantages of mutual funds are no secret. By pooling your money with that of many other shareholders, you can get wide diversification (hence less risk and more opportunity) with a modest investment of as little as a few hundred dollars.
Mutual fund shares are very liquid. At the end of every business day, you can sell your shares back to the mutual fund company at the exact price they are worth — that is, the value of the underlying securities and cash in the fund’s portfolio.
You also get professional management and access to stocks and other investment products that would be difficult if not impossible for most individuals to achieve. Most mutual funds make it easy for shareholders to make automatic periodic additions to their accounts and automatic withdrawals.
Funds are subject to government regulation and must report their key information in standard ways that make comparisons among funds easy.
Mutual funds aren’t perfect. They asses fees for administrative and management costs, and they don’t let shareholders in taxable accounts control the timing of capital gains and losses.
Before the advent of index funds in the 1970s, fund managers’ active buying and selling in their portfolios created taxable income for shareholders, including those who didn’t do any trading themselves.
Even worse, fund expenses were often very high, typically taking away one to three percentage points of the return that a fund’s portfolio earned for shareholders. This provided a lucrative business for the companies that managed mutual funds.
Then John Bogle disrupted the industry in 1976 with the introduction of the index fund, the second crucial building block of the strategy I’m laying out.
Index funds managed to bypass highly-paid managers by letting investors participate in virtually every stock within an asset class such as the Standard & Poor’s 500 Index. Expenses could be cut to the bone — often by 90% or more — and taxable events could be minimized. More diversification and less risk were strong selling points.
Because index funds were sold on a no-load basis, investors could get all these benefits without paying sales commissions that amounted in some cases to more than 9% of the money that was actually invested.
For many years, Wall Street tried to fight index funds, but the low costs of index investing made the fight an uphill battle.
All these changes were in the best interests of individual investors. Higher net returns meant more money in retirement, more money to leave legacies — and for some people they also meant the possibility of earlier retirement.
Over the past 40 years, index funds have found widespread acceptance. Costs to shareholders have come down, in a few cases to zero. And index funds now hold trillions of dollars in investment assets for individuals, corporations and other institutions.
Although the first index funds concentrated on large-cap blend stocks, often represented by the S&P 500 Index, there are now separate index funds for many U.S. and international asset classes. This means ordinary investors can build low-cost portfolios with massive diversification that are custom-tailored to their individual needs.
Over the past half century, the index fund has been a true game-changer. For more about the favorable attributes of index funds, check out this article.
But index funds are not perfect. For most people, their biggest shortcoming is the lack of a “glide path” that reduces the level of risk as shareholders age.
Investors who hold index funds certainly can make changes themselves over time. For example, you can sell some shares of an equity index fund and put the proceeds into a fixed-income index fund when you reach a certain age.
But this requires you to make a decision and take action to implement it. Unfortunately, the majority of investors do those things poorly, or too late, or not at all.
To the rescue: The target-date retirement fund. For the first time, mutual fund managers have a responsibility to take into account the needs of individual shareholders. Of course we are not talking about individual management; this is a mutual fund, after all.
Target-date funds let each shareholder choose a fund based on his or her projected date of retirement. The underlying idea, which in my view is generally valid, is that everybody who plans to retire in (or within a few years of) 2050, for example, has a “glide path” with similar requirements for gradually reducing risk.
Within a “2050” fund, the managers can gradually reduce the proportion of equity index funds while they gradually increase the proportion of fixed-income index funds. That is a way to mass-produce the same general effect that a pension fund might apply to future retirees.
A “2025” fund will be managed much more conservatively, since its shareholders presumably plan to retire much sooner. These people can’t afford to have most or all their money in stocks, since a major market decline could wipe out enough value that they could be forced to delay their retirement.
For investors who want to make a single investment decision that is likely to serve them well the rest of their lives, a target-date fund is a terrific product.
However, target-date funds aren’t perfect. We’ll dig into those imperfections in the next article in this series. We’ll follow that up with a “two funds for life” strategy that could double your retirement income and at the same time provide much more for your heirs.
For more about these three great products (the mutual fund, the index fund, and the target-date retirement fund), check out this podcast.
Richard Buck contributed to this article.