This article, Smart Ways to Invest in Stocks, is all about increasing our odds of investing success. Investing in stocks is a terrific way to build wealth, however there are many mechanisms and methods to do this. To this end, we will be looking at three sets of opposing ideas and selecting the best of breed to arrive at an optimal approach. So as we look at each set of opposing ideas, we will carefully evaluate each, and carefully choose the best. Because the simple truth is that investing in stocks is easy, efficient, and can deliver tremendous long term returns. Many investors will try and over complicate things but we can actually do better if we simplify and stick to a long term plan.
Here are the three sets of opposing ideas:
Index Fund vs. Individual Stocks
Right out of the gate, let’s tackle one of the biggest opposing view points when it comes to smart ways to invest in stocks: index funds or individual stocks.
The Case for Index Funds
The core principle of investing in stocks through an index fund is diversification with super low costs. Instead of owning some stocks, why not own them all and be fully diversified across all industries and companies. However, before we go further, what is an index fund?
Index Fund Definition
An index fund is a type of investible instrument with a portfolio constructed to match or track the exact same stocks of an index, such as the Standard & Poor’s 500 Index (S&P 500).
Benefits of an Index Fund
An index mutual fund is said to provide broad market exposure, lower operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets. Over longer periods of time, investors who put the majority of their investments in index funds have typically fared much better than all other investor types.
- Less taxes paid
- Lower costs and management fees
- Few if any trading fees, possibly zero through certain brokerages
Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs), 401(k), RRSP, TFSA accounts. Legendary investor Warren Buffett has recommended index funds for the vast majority of investors.
Less Volatility
On top of the benefits listed above, another benefit of index funds, and what makes them one of the smartest ways to gain exposure to stocks, is that you lower your portfolio volatility while earning your expected stock market return. The following chart hammers this point home. It shows the market returns for the last 45 years against all other NYSE listed stocks for the same period.
Notice that while the returns of the S&P 500 are squarely above the average of all the stocks, the volatility is second to none. In other words, the index offered the best risk adjusted returns. Not one single stock offered less volatility; diversification in action! This also means that this investment vehicle stood the best chances of being held for the long term and allowing the magic of compounding returns to do its thing.
The Case for Individual Stocks
The attraction for investing with individual stocks is the opportunity to make it big and generate outsized returns in a shorter timeframe than what can be achieved through an index. The prevailing argument against index fund investing is that the returns are dragged down by all the loser companies within the index. So instead, pick out the winners and get better returns.
It is true, if you can pick a winning company and ride it out for a number of years you can make a substantial amount of wealth in a shortened time frame. One of the best examples of this is Microsoft. I wrote a detailed article last year about the incredible returns this company generated for investors over the last 30 years. So the argument goes, if you can find the next Microsoft, you can literally change your life.
Best in Breed
For the vast majority of investors, the best solution for long term investing is to go with the index fund approach. The odds are in your favor when you deploy this strategy you are guaranteed to have results that will beat the majority of all other investors.
That being said, if you have incredible conviction for a particular company, feel strongly about their prospects, and have a good understanding of their business, there is nothing wrong with picking up a few shares on the side. However, your core holding should be an index fund strategy with a maximum of 10-20% invested in individual stocks you are incredibly passionate about.
Tax Sheltered vs. Margin Account
Next in our set of opposing views on the smart ways to invest in stocks is should we use a tax sheltered account or a non-sheltered one, such as a normal margin account.
The Case for Tax Sheltered
Government endorsed tax sheltered accounts come in many forms to incentivize people to save for specific goals. For example: retirement, education and disabilities come immediately to mind. As we all likely have to retire from active employment, we can use this account type for saving and investing. In America this often takes the form as a 401(k) or Roth IRA, while in Canada the equivalents are RRSPs and TFSAs respectively.
The benefits for these accounts are two fold. Firstly, all interest, returns and capital gains are left to grow without being taxed. Secondly, they offer a tax benefit either when you deposit or withdraw your funds. So, in the case of a 401(k) and RRSP you get a tax break when you contribute which effectively lowers your taxable income. Additionally, employers will often match your retirement account contributions as a perk, and thereby increase your savings rate even faster. While in the case of a TFSA and Roth IRA, withdrawals are not taxed.
To counter balance these tremendous benefits, governments will often impose limitations on how much you can contribute to each account. They will also restrict the types of investments you can purchase and you are not allowed to buy on margin or borrow within the account to buy more shares.
Despite these limitations and restrictions, these investment accounts are incredible investment schemes. They deliver real results over time, and lower your taxable income either before or after contributing.
The Case for Margin Account
The margin account is your typical investment account through an online brokerage. There are no limits on how much you can deposit, invest, or withdrawal. On top of this, any and all investment types and strategies are permitted including borrowing against securities, shorting stocks, and complex option orders.
This type of flexibility comes with a cost, specifically all returns, interest and dividends are taxed. Furthermore, the effort to record and detail each trade is required by law so you can properly calculate the tax you owe. At times, the complexity of an active account can be such that services of an accountant are required.
The benefit of these account types is the incredible level of liquidity they provide and seemingly unlimited investment options and strategies. Lastly, with no restrictions on contributions or withdrawals you can make significant investments without consideration on the same.
Best in Breed
The smart way to invest in stocks using this approach is to first, open your tax sheltered retirement accounts and begin maxing these out each year. After you have that topped up, begin putting money into your taxable account. As your investment skills improve and increase you will find your groove and how best to strategize between the two account types and leverage the unique benefits of each.
Trade vs. Buy and Hold
The spotlight will always be reserved for those who have generated massive returns in short periods of time. Conversely, how many movies have been made about buy and hold investors who subscribe to the strategy of passive index investing? The fact will always remain that short bursts of productive active trading will always sell headlines and make the news while the boring passive investor will be left alone. Let’s dig into each approach a little deeper.
The Case for Active Trading / Market Timing
The active trader is constantly scanning the market for opportunities to deploy their capital for maximum returns in the shortest amount of time. Furthermore, they believe their time, talent, abilities and investment acumen will be rewarded through active participation in the market. While it is true there will always be successful traders who capture our attention; the fact remains that the odds are not in our favor. Regardless of talent, our ability to successfully trade for maximum gains on a long term basis is close to zero.
Consider that most professional money managers, who are paid based on performance, rarely beat the market returns. Some managers and hedge fund traders will beat the market this year, while some will do it next year, however the names are constantly changing.
The case for active trading is weak at best. You will need to be right on 74% of your trades just to match the performance of the benchmark index after factoring your costs.
The Case for Buy & Hold Investing
Far and away, your best approach is to employ the buy and hold approach with passively managed index funds.
Bring it Together
In summary, let’s bring this all together and outline the smart way to invest in stocks. Firstly, we want to invest in broad based index funds with low fees. Secondly, we want to invest heavily into tax sheltered accounts so we maximize our returns. Thirdly, we want to avoid actively trading and instead stay invested through the market ups and downs.
Combining these three approaches will give us the best chance of capturing and earning the promised stock market returns for our portfolio and grow our wealth the fastest. It’s ironic that the best way to invest is to do less and rely on compounding returns to do the heavy lifting.
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