Doc's note: In today's issue, Austin Root details the best way to maximize investment gains for your nest egg over the long run. It's a simple step to take, but one you'll often hear others argue against...
Today, I want to make one simple yet incredibly important point about investing.
You've probably heard the opposite argument made many times before, often by smart and experienced folks. So I may be facing an uphill battle here.
But I want to hammer home this point because I believe that right now – more than ever – your commitment to it will be the best way to maximize investment gains for your nest egg over the long run.
So here it is...
For the vast majority of your capital, don't buy mutual funds or exchange-traded funds ("ETFs"). Buy individual stocks.
To be clear, I'm making this argument with one qualification: time.
Choosing to invest only in mutual funds or ETFs will save you time. So if that's the most important factor for you, go with the funds. But if not, all investors should be invested primarily in individual stocks (especially now, with the spread of commission-free trading).
I can think of nearly a dozen reasons to put the majority of your money into individual stocks rather than plowing it all into funds. Today, I'll take a look at two of the most important reasons, starting with the most controversial...
1. Over the long run, individual stocks will outperform funds.
I know. You've probably heard about numerous studies showing the opposite... that over time, most professional investment managers who manage individual stocks (i.e. "actively managed mutual funds") underperform the broader market index.
Anyone who prefers to invest in a "passive" index fund or ETF loves to point this out. But those studies have two main problems...
First, they're typically an apples-to-oranges comparison in which the actively managed fund returns are after fees, while the index performance is before fees. It's true that management fees have come down over time. But industry-wide, they still chop off about 1% per year from average net returns. That may not seem like a lot, but over time, it really adds up.
Consider two investors, A and B. Both start with $100,000. But Investor A generates 9% per year in gains (reinvested every year) for 30 years, while Investor B generates 10% per year. After 30 years, Investor A's nest egg is worth $1.3 million. Investor B has more than $1.7 million.
In other words, Investor B's 1% higher annual returns translate to 34% higher total gains given the power of compounding interest over time.
When you strip away the fees, actively managed funds perform much closer to the broader market. And they've often materially outperformed. So, if you manage your own money – avoiding management fees – that gives you the clear advantage as a stock-picker.
There's another key problem with studies that claim most professional investment managers underperform the broader market... They tend to measure against all mutual funds, not just the ones that are truly actively managed.
In other words, they include many managers that aren't trying to beat the market at all, and instead, own essentially all the same hundreds of stocks as the benchmark they're competing with.
To eliminate those "closet indexers," a newer analysis has been done on investment managers with high "active share." These are managers that do not simply mimic some market index, but instead make more concentrated bets in fewer stocks that they truly believe in. And when looking just at these managers, the stock pickers generally do outperform.
One recent study by Invesco shows that since 1994, more than 60% of investment managers with high active share have outperformed their benchmarks... even after fees.
All of that is to say that if you avoid high fees, pick the right stocks, and concentrate on your best ideas, you should beat the market over time.
2. When you know what you own and why, you'll make better decisions.
I can't tell you how many investors I speak with who have no idea what they own, let alone why. And this includes many professional investors who get paid to manage money on behalf of their clients!
Knowing what you own will help you out immensely when stocks are grinding higher. You'll have courage in your convictions and be able to let your winners run when less-informed investors tend to sell.
But knowing what you own might be even more valuable when things go very badly for the market. And they will – that's just what markets do. When that happens, knowing what you own will enable you to act more clearly and decisively.
If you hit trailing stops on certain positions, you'll sell what you need to and take some risk off the table, building valuable dry powder. Then, when other investors are either frozen with fear or begin panic-selling near the market bottom, you will start your shopping spree... buying only things you know well. You'll buy those world-class companies that you're confident will ride out the downturn and recover with a vengeance, taking market share along the way.
Consider the brilliant thoughts that Porter Stansberry shared during one of our webinars in March. Remember, this was after the market crashed and left nearly every other investor in panic mode. He said...
My hope is that you, our Stansberry Research subscribers, have followed your trailing stops as we've been advocating. You've done the right thing. You've built cash on the way down. Fantastic. Now... using trailing stops is smart, but only if you're willing to get reinvested. So you sell and generate cash on the way down. Hopefully somewhere in the range of the bottom, you begin to reallocate.
Now, you're not going to always know the exact day the market bottoms. Nobody's that smart. But what you want to do, is begin buying. You don't want to buy all stocks. Focus intently on buying stocks that you can comfortably hold forever.
Right now is a chance for you to buy the highest-quality businesses in the world for the same price in terms of earnings multiples that we saw in 2008 and 2009. I thought that was gone forever. This is the opportunity that you've been waiting for. So why not take that chance? At least take half the cash you've built and put it to work.
Now, should stocks fall further from here, if you've bought the right businesses, you'll still be fine. And you've got more cash – because you only used half so far – to buy even more at even better prices.
What I don't want you to do is get so frozen that you won't take any action.
So, we may not be at the bottom, but we're really close. And I want you to get ready. I want you to have your names researched and lined up. I want you to know what you're going to do with your cash, and I want you to make it automatic because you have a plan and you're going to follow it.
Porter was spot-on. Owning individual stocks will help you know what you own. That knowledge will give you confidence when everyone else is uncertain and agility when everyone else is frozen.
It will help you stick with your winners for longer on the way up... happily part with some of them when stops are triggered on the way back down... and then, when the crash is over, act decisively to buy world-class companies at fire-sale prices.
Editor's note: If you want to learn about some of the best investments you can make this year, don't miss tomorrow night's special briefing. Whether you're all-in on the bull market... nervous that another crash is just around the corner... or simply overwhelmed with what's happening in the world... don't miss our urgent briefing tomorrow, Tuesday, January 26 at 8:00 p.m. Eastern time.
It's totally free for you to attend. Just sign up here.