Really Simple Investing

Most people wish they didn't have to be investors. They lead busy enough lives without having to worry about stocks, bonds and mutual funds. For these folks, investing is a daunting chore -- about as much fun as fixing a leaky toilet or visiting the dentist. If that description fits you, please read this column. If, like me, you get a kick out of investing, please e-mail this column to friends and relatives who don't. They'll thank you for it.

Most of my columns are aimed at fairly sophisticated investors. These investors are willing to take the time to learn about the best actively managed funds in the hopes of earning a percentage point or two a year more, on average, than the market over the long haul.

But there are no guarantees. Picking actively managed funds that will beat their benchmarks is hard as the dickens. All I can guarantee is that in many years you'll fail -- no matter how savvy an investor you are and how much time you devote to investing.

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The numbers bear me out. Roughly two-thirds of actively managed funds fail to beat simple index funds.

I love mutual funds. What started as a hobby for me grew into a passion and eventually became my livelihood. I believe that by carefully studying the numbers and the people who manage mutual funds, you can pick winning funds.

But most people lack the patience, energy and time to beat the market. And they shouldn't try.

What to do?

Stick with index funds. Rather than trying to beat a benchmark, index funds dare to be average. They aim merely to mirror a market barometer, such as Standard & Poor's 500-stock index or the Wilshire 5000 or the Russell 2000. Consequently, they don't require any monitoring. It doesn't matter much whether the manager leaves or stays put. Index funds have such an easy job that they tend to achieve their goals no matter who's in charge.

The best index funds -- those provided, most notably, by Vanguard and Fidelity -- accomplish their humble task with aplomb while charging investors a pittance. Expenses range from less than 0.1% of assets annually to a still-modest 0.35% annually. By contrast, actively managed funds typically charge more than 1% for annual expenses (that doesn't include sales commissions, which many funds charge). Index funds derive their advantage almost entirely from low costs. If you come upon a high-fee index fund, avoid it. A cheaper fund will always perform better (assuming you're comparing funds that mimic the same index).

In recent years, a new kind of index fund has become popular. Exchange-traded funds (ETFs) are merely index funds that trade like stocks. Are ETFs better than old-time index funds? For a lump sum, a good ETF (such as those sponsored by Barclay's Global Investors at www.ishares.com) will be a tad cheaper. If you're investing small amounts every month or so, regular index funds are slightly better. But for most investors, the difference is microscopic. Both are good choices.

What's unfortunate is that Wall Street, as usual, has taken a good idea to wretched excess. By last count, there were 359 ETFs. They invest in everything from Chinese stocks to semiconductor stocks. And financial companies are launching new ones practically every day. These narrow ETFs make no sense whatsoever for investors. The main people they stand to enrich are those who market them.

For many ordinary investors, the plethora of new ETFs has led to investment paralysis. It was hard enough trying to choose among the thousands of actively managed funds. Now hundreds of ETFs likewise clamor for your attention. Last week, I came upon a piece of brokerage research that suggested building a portfolio with no fewer than nine ETFs. The commissions assembling such a portfolio generates may be good for brokers, but not for investors.

Suggested index-fund portfolio

Want to invest with a minimum of fuss and a maximum of simply? All it requires are three index funds. You can turn to either Vanguard (www.vanguard.com 800-635-1511) or Fidelity (www.fidelity.com; 800-544-6666). I prefer Vanguard because the firm is organized in such a way to suggest that its prices will likely always remain rock-bottom.

Put three-quarters of your stock money in Vanguard Total Stock Market Index (VTSMX), which covers the entire U.S. stock market. Stocks of large companies get the lion's share of your money, but midsize and small companies are also well represented. Invest the remaining fourth in Vanguard Total International Stock Index (VGTSX). It gives you the rest of the world.

For your fixed-income money, use Vanguard Total Bond Market Index (VBMFX). If you're investing in a taxable account, substitute an actively managed bond fund, Vanguard Intermediate-Term Tax Exempt (VWITX). It invests in high-quality municipal bonds.

How much should you put into bonds? If you're investing for retirement, keep 90% or more in stocks until you're within six years or so of retirement. Then gradually start selling your stocks until you're 40% in bonds by the time you retire.

If you're investing for your child's education, also start with 90% or more in stocks and begin scaling back when he or she gets within ten years or so of college. Then gradually sell your stock funds first and then your bond funds until you're entirely in cash by the time your child is midway through college.

Does 90% or more in stocks seem too risky? The math is simple: Stocks are volatile, but they've always been the long-term winners, returning more than 10% a year on average since 1926. Bonds have produced about half that. Inflation, meanwhile, has averaged 3%. Put less in stocks if you think you're likely to bail when the market tanks. You'll do fine with 80% or even 70% in stock funds. But if you have the stomach for it, put 90% or more in stocks.

That's it. That's the whole plan. Investing really can be simple. There's just one key ingredient that I can't supply you: fortitude. For any investment plan to work, you need patience. You need to stick with the program -- especially when it doesn't seem to be working. For instance, in the 2000-02 bear market, broad-based index funds lost nearly half their value.

But if you follow this simple plan and stick with it even when markets turn inhospitable, odds are you will do well. Based on past results, you'll beat at least two-thirds of other fund investors. And you'll have more time to ponder things besides how to invest your money.

Steven T. Goldberg is an investment adviser and freelance writer.