I came across an article on Fortune called 10 Rules for Building Wealth. I respect Fortune, but one particular step of this article was very poorly put forth. Actually, I think 9-and-a-half of the 10 steps were good advice. Typical stuff- use tax-advantaged accounts, eliminate credit card debt, keep fees low, and that sort of thing.
Part of one of the steps, however, I think outlines one of the worst popular concepts in personal finance today. Here it is, and why I think it is not worth following:
Step Three- Keep it simple
If you have a full-time job and it’s not picking stocks, acknowledge that. Choosing three or four index funds – say, an S&P 500 fund, an EAFE fund, and a small-cap stock fund – will give you broad exposure. ETFs (low-cost mutual funds that trade like stocks) are also an easy way to invest in more exotic asset classes, like commodities.
Clarification from myself: An index fund is a list of stocks that fit a certain criteria (like US small caps, top foreign companies, or 500 most profitable companies) that you invest in. Your investment will follow the returns of the market, and nobody is actually picking the companies as good investments. You will be invested in hundreds of companies that meet the criteria and likely won’t even know what most of them are. If the economy goes well, your investments will generally grow. If the economy does poorly, the opposite will usually occur.
In my opinion, this is a really bad mindset, and also one of the most commonly followed ones. For the past several hundred years, people have become more and more specialized. No longer do we learn how to obtain food from the land, learn how to fix things, or even learn how to manage our estate. This is an era of outsourcing. Let skilled laborers fix everything you own. Let engineers make all that technology that keeps you comfortable and alive, and don’t bother trying to understand any of it even a little. Let financial planners and automated index funds handle all of your hard-earned assets. That’s right: pay others to think for you. Just go to your cubicle and make widgets like you’re supposed to, you good little lemming you.
Sarcasm aside, (and although I admit I don’t obtain food from the land), I really think people need to be well-rounded. We certainly can’t control and understand everything around us because there’s just too much, but we need to at least grasp a lot of what affects us. I don’t have any problems with index funds. It’s the MINDSET of the article that I dislike. I’m being a little harsh, because the article doesn’t directly say not to pick any individual stocks along with your index funds, but that opening sentence just sums up a poor mindset. Index funds and broad ETFs certainly can have their place in a well-rounded portfolio, and I even recommend that they are used if that’s what your company’s 401(k) or similar tax-advantaged savings plan offers. Index funds allow you to instantly diversify your portfolio, because by buying an index fund, you’re following hundreds or thousands of stocks, automatically.
But is that how you want to live your life? Automated and 100% dependent on the broad economy? Outsource all of your responsibilities and assets to a list of companies that you aren’t familiar with? That’s how you build mediocrity, not wealth. An index fund contains hundreds of companies, and you don’t know anything about most of them. By buying an index fund, you’re just placing a bet on the future of the economy. Between 2000 and 2010, you would have gained nothing by buying an index fund that follows the S&P 500, since the economy went nowhere. Overall, the odds are in your favor with index funds at least compared to holding the money in savings accounts or bonds, since the long-term historical return has been greater than those investments, but the history is no guarantee of the future.
I suggest that you consider using the above useful tools (index funds, ETFs), but also work to become financially literate. It’s true, your full time job may not be to pick stocks, but you’re not defined by your full time job, are you? Are you going to avoid doing any home improvement yourself because you’re not a carpenter? You might actually enjoy building something of value. You have other abilities besides those in your job description, and a learned man or woman is a well-rounded man or woman. I’m not saying you should spend all your time researching stocks, but I am saying that you should at least understand much of what you own and why you own it. If people are going to complain when the economy crashes and they’ve lost their investments that they didn’t even understand in the first place, then I feel their pain, but part of it was their own fault.
On this site, I recommend investing a good chunk of your portfolio in dividend growth stocks. They do take some learning, but most of the work is up-front. Dividend-paying companies tend to be more stable than other companies. Sure, some dividend payers crashed during the economic crisis, but not most. The trick is to buy companies you understand. Do you understand AIG? Do you understand the financial behemoths of Bank of America and Citigroup? Even experienced accountants have trouble digging through their epic balance sheets. Look around at what products you own, what services you use, and get investment ideas from those things. Become financially literate so that you can evaluate investments and begin to make them, or at least have someone you trust make those investments and make sure you understand yourself what you are invested in and why. You’re never going to understand everything there is about a company, and there is always risk, but in order to mitigate risk you have to understand what risks there are.
Becoming financially literate, and understanding and even choosing your own investments not only helps you take control of your financial destiny, but gives you a successful wealth-building mindset. Not everyone out there has the skills to learn to invest, but I would wager that most of the people reading this article do.
As a side note, right above this article on Fortune’s feature, another article was called “10 Stocks to Buy Now”.
Their number 1 stock to buy in 2007 was AIG. Anyone who has watched the news even once in late 2008 or early 2009 will get the joke.
I love comments, so let me know how you feel.