Automatic Boring Investing
A recent episode of the Planet Money podcast told the story of an open challenge Warren Buffett posted to hedge fund managers. Buffett bet that his boring, brainless investment would outperform the smartest hedge fund managers’ investments. Buffett’s claim is that a passive investing strategy will outperform an active one.
In 2006, Warren Buffett posed a challenge. He bet that the smartest hedge fund managers out there couldn’t beat the…www.npr.org
Generally, a passive investing strategy is one that attempts to invest in the entire market (usually a representative subset like the S&P 500) via index funds, while an active investing strategy involves fund manager picking specific stocks, usually in an attempt to beat the market. The Planet Money episode gives a good overview of these competing investing strategies.
When the topic of investments comes up while talking to friends, family, and coworkers I often hear signs of investing paralysis; e.g., never selling their company’s stock they receive, or not investing at all and hoarding cash. There’s also the other extreme where amateur investors think they can beat the market, but their investing strategy is usually built on overconfidence and biases. Previously, I’ve been part of both these camps, but sought out a different strategy…
In this post I provide details on how I’ve taken the boring/passive investing strategy and automated it.
I’m not providing you financial advice. But I do want to help change the sentiment around talking about money and investing by sharing my approach and information that I think is useful for people know. Everyone is on their own to save for their future and I think we should be discussing it more with the people we trust.
Choosing an Index Fund
To implement a passive investing strategy I wanted to choose an index fund for broad market diversity. Since index funds by their nature track a market index (like the S&P 500), they are very similar across different financial institutions (e.g., ETrade, Fidelity, Vanguard, etc.) The main requirement was being economical to make periodic investments into the fund—the automatic part. Index-tracking investments can be packaged as a mutual funds or Exchanged Traded Funds (ETFs), to determine which would be best for my approach I weighted them on these qualities:
- Minimums: The minimum initial investment, and minimum per each additional investment.
- Expenses: The expense ratio, and expense per additional investment.
- Automatic Investing Tools: The financial institution’s tools for automatic, scheduled investments.
Index-tracking ETFs, like $SPY, will have a lower initial investment requirement than a mutual fund because you only have to buy one share. Mutual funds generally have a $2,500+ initial investment requirement, and they might have a minimum additional investment of $250+.
Expense ratios of index funds and ETFs are very low compared to actively managed funds because they don’t pay fund managers to pick stocks. But with ETFs being traded like a stock, there will likely be a fixed trading fee attached to every transaction of ~$10.
When researching the automatic investing features of major consumer financial institutions, I found they only supported automatic, scheduled investments for mutual funds, not stocks or ETFs. This lead me to search for an index-tacking mutual fund with a low expense ratio and low or no minimums for additional investments…
I ended up opening an account with Vanguard. They were founded on the idea of index funds and pioneered them. Vanguard is setup in a client-owner organizational structure, similar to a credit union, meaning Vanguard itself isn’t a publicly traded company. This allows Vanguard to offer the lowest expense ratios in the industry because their clients are the owners, and owners/clients are compensated via lower fees.
Vanguard has 17 index funds, including the Vanguard 500 Index Fund that Warren Buffett invested in for the bet mentioned on the Planet Money podcast. Vanguard’s index funds match all the qualities I wanted for an automatic, passive investing strategy:
- Minimums: $1 minimums for additional investments.
- Expenses: Expense ratios as low as 0.05%, no trading fees.
- Automatic Investing Tools: Good automatic/scheduled investing tools.
Reducing the Impact of Market Volatility
A problem with any investing strategy is trying to buy when the price is low, in the troughs. The worst is if you buy at the peak, right before a downturn — in the last year there have been two peaks followed by rapid downturns:
Dollar Cost Averaging
Instead of making a small number of large purchases which have exposure to market volatility risk, a large number of small purchases can be made over a regular interval for the same dollar amount. This is called Dollar Cost Averaging. Since the same dollar amount is invested each time, more shares are purchased when the price is low, and less shares when the price is high. Mutual fund shares are priced at the net asset value (NAV) of the fund’s holdings at the end of the business day. When you place a buy or sell order during the trading day, the order won’t be executed until after the market has closed.
This means if I make a small additional investment everyday, I’ll be applying the principle of Dollar Cost Averaging to its maximum. This would be very onerous to do manually; so here’s how I automated it…
Setting Up Automatic Investments
To illustrate the automatic boring/passive investing strategy, let’s use a goal of investing $50 a week.
Investment accounts at financial institutions like Vanguard will have a settlement fund, which is usually a money market fund or cash account. This is where you can deposit cash, use that cash to buy shares in a mutual fund, and where the cash proceeds go after a sale.
Automatic Transactions, Repeated Weekly
These are the weekly automatic transactions that I set up, using $50/week as an example:
- Monday: Transfer $50, Checking → Vanguard Settlement Fund
- Monday: Buy $10, Vanguard Index Fund
- Tuesday: Buy $10, Vanguard Index Fund
- Wednesday: Buy $10, Vanguard Index Fund
- Thursday: Buy $10, Vanguard Index Fund
- Friday: Buy $10, Vanguard Index Fund
I was able to set up all the transactions using Vanguard’s automatic investing tools, which were flexible enough to allow scheduling multiple weekly automatic transactions. It took 10 minutes to setup.
Now I’m investing every day, in an automatic, boring way.
Is This a Good Idea?
The other week, The New Yorker published this article which warns that passive investing might not be a good idea:
If you have so much as tiptoed into the arena of personal finance over the past few decades, you will have heard about…www.newyorker.com
Timothy O’Neill, the global co-head of Goldman Sachs’ investment-management division, told me that essentially every new indexed dollar goes to the same places as previous dollars did. This “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,” he said. O’Neill fears that the result will be a “bubble machine” — a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be. (As an investment bank, Goldman Sachs profits from management fees, though it also sells E.T.F.s.)
Goldman Sachs’ business is charging management fees in exchange for its financial services, so it’s logical for them to have a negative view of passive investing. If “Smart Money” is smart and can beat the market, then they’ll be able to continue charging fees for their services. The problem with fund managers is most are horrible at picking stocks:
If most professional stock pickers—whose full time job is to use sophisticated technical analysis tools to pick stocks—are bad at picking stocks, then an amateur investor should not expect to do any better. People know that picking specific stocks is risky and many aren’t confident about what stocks to buy and when to buy/sell them, resulting in investing paralysis. This leaves them in situations where they don’t have savings, are cash-heavy, are over-exposed to risks they aren’t aware of, or paying high fees to financial institutions and advisors.
With current interest rates being practically 0%, and people on their own to save for retirement, investing in equities is the primary way to save money and get a return. Many of us are recognizing that old default of putting money into actively managed funds that have higher expenses for lower returns is flawed, and we’re moving our money into index funds.