I Bought What I Knew

First a personal story: back in 1988, I was working in the customer service department for a company that made electrical products.  One day the Vice President of Sales called a special meeting.  “We need to change the way we do business”, he said.  “We believe that one of our customers will grow exponentially in the coming years and we need to be ready for this growth.”  The customer he was talking about was Home Depot.  I went back to my desk and thought that if our 100 year-old company was going to change the way we do business for Home Depot, then they must really think this is an amazing company… so I bought some stock.
This turned out to be one of the best investments of my life.  I carefully watched their purchase orders float in every day, while they opened new stores at a groundbreaking pace… I was literally watching Home Depot burgeon every day from my desk at work.  Not only did I buy stock once, I signed up for their dividend reinvestment plan and direct stock purchase plan and continued to buy every month for years.

Now I don’t recommend you buy a company’s stock just because you like the company.  This is just a starting point to identify companies you want to investigate further.

Peter Lynch

Buying what you know is what made Peter Lynch one of the most successful mutual fund managers in history.  He ran Fidelity’s Magellan Fund from 1977 until his resignation in 1990, growing it from $18 million to $14 billion, using the buy what you know technique.

His wife and daughter shopped at The Limited before anyone on Wall Street even heard of it, allowing Lynch to make a killing.  He investigated Apple Computer because his kids owned one, and researched Pier One because his wife shopped there often.  Taco Bell appeared on his radar after he enjoyed a Burrito Supreme (hold the sour cream), and he found Volvo because his family and friends owned their cars and loved them.

The Book

After retiring from Fidelity, Lynch decided to share his investing techniques with the world through his first book One Up On Wall Street: How To Use What You Already Know To Make Money In The Market. This was the first book on investing I ever bought, and in my opinion it is still the best.  Lynch focuses on the power of common knowledge and how to take advantage of what you already know.  He believes you don’t have to be a Wall Street analyst to uncover great investment opportunities, and in fact you may actually have an advantage because of it.  If you want a great book on investing, this is it.  Additionally, Lynch’s second book,  Beating the Street, is amazing as well.

If you want to be a successful investor, you need to own these books. And you need to start paying attention to where you shop, what you like and what you see.

Image via Wikipedia

Slow and steady wins the race, and Index Funds are indeed a slow and steady way to make money in the stock market. If you want a get rich quick scheme, read no further. Warren Buffett, the most successful investor in history, has said it over and over again: “The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time”. There are three key phrases here: “index fund”, “low-cost” and “buying regularly over time”.

What’s an Index Fund?

Before we dive into Index Funds, let’s discuss their counterpart: the Managed Fund. These are the original Mutual Funds. Typically you are paying a manager or managers to pick stocks for you. They do research, make phone calls and visit companies they want to invest in. This amount of work can cost you some bucks. Most managed funds charge at least 1% for this service, with some moving closer to 3%. So, for every $100 you invest you pay $1-$3 dollars, for every $1000 it would be $10-$30. This is not a small amount, and will add up over years of investing. It would be worth it if the returns were great, but usually they are not.

Index Funds are like regular mutual funds, except they follow a specific index. The most popular index is the S&P 500, which is an index of the 500 largest American stocks. As you probably guessed, there really isn’t a lot of work involved in determining this list. It’s pretty automated. The result is that you pay a reduced fee. S&P 500 Index funds typically charge less than .5%. The most popular of the group is Vanguard Funds which charges a fee of .15%; that’s only 15 cents for every $100 you invest!

A common mistake is that if you’re paying more, you must be getting more. Managed funds must perform better than index funds. The truth is that over 90% of managed funds UNDER perform their target benchmark over the long haul. And their target benchmark is usually an Index Fund.

Vanguard Funds founder, John C. Bogle, was really the guy to bring index funds to the masses. For his undergraduate thesis at Princeton, Bogle found that three out of four fund managers could not outperform a passively held basket of the 500 largest US stocks. They may end up picking specific stocks that do as well, but paying high expenses associated with their research and taxes incurred during active trading, just resulted in their funds under performing the S&P 500. Bogle is the king of index funds. He built the well respected Vanguard Funds on that philosophy and even wrote a great book about common sense investing which highlighted index funds.

Low-Cost is the key

The secret to successful index fund investing is low expense. Why pay more for a list of companies that require no research? Get the prospectus or visit Google Finance or Yahoo Finance for the fund you want to invest in and check the expense ratio. You should aim for .5% or less. Other things to look out for are the minimum investment and account service fee. For example, to get Vanguard’s low expense ratio of .15%, you need to make a minimum investment of $3,000 in the fund. An annual $20 fee is tacked on to your account if it’s less than $10,000, unless you sign up for e-delivery of statements and some other bells and whistles. So research the fund expenses before you send them any money.

Buy regularly over time, because you can’t time the market

Nobody can time the stock market. Warren Buffett has never called a market high or a market low, so seriously, what chance do you have? By buying regularly over time, you adhere to the old standby of dollar cost averaging, which works very well.

Image via Wikipedia

So, you still aren’t convinced that index funds are a great choice for you? Well, maybe this will convince you. Warren Buffet is so sure that the S&P 500 will outperform an actively managed fund over the long term that he bet over $300,000 that they would: “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.” If I can’t convince you, hopefully Buffet can.