Best Investments For Novice Investors

Posted on January 15, 2014 at 2:26 PM PDT by

For many people, the first step is the hardest. As a result, the novice saver and investor ends up being in cash.

And that’s where they stick, for years. The 401(k) industry has slowly moved toward “opt-out” plans with target-date funds precisely because people won’t start saving, save far too little or sit in cash for decades.

What’s wrong with cash? Inflation, for one thing. Even moderate inflation slowly diminishes the value of your money.  Ten thousand dollars in 1983 is the equivalent of $23,389 today. You would have to grow your money at least at the inflation rate to avoid falling behind.

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Nevertheless, buying stocks and bonds with better returns is daunting. As a result, savers are shepherded into mutual funds run by money managers, who buy stocks or bonds on their behalf. In the case of target-date funds, it’s often both, and the manager winds down the risk level over time.

That’s a great innovation, but the downsides of mutual funds and target-date funds are numerous.

Mutual funds, for instance, rely on the notion that a given manager will outperform the market. Once you add in the ongoing fees of active management, that goal becomes less and less likely.

Target-date funds have the same risk. They purport to solve a problem — painless, reliable compounding — while virtually guaranteeing a subpar experience thanks to the fees they charge.

So what’s a novice investor to do? One way forward is to simply buy index funds instead of mutual funds. If you seek the return of the S&P 500, you aren’t going to get much closer than by owning an S&P 500 index fund or ETF. Such funds use computers to replicate the index and charge a tiny fraction of the fees charged by active managers.

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If the idea of “set it and forget” appeals to you, then an alternative to a target-date fund might be one of the Vanguard LifeStrategy Funds. Being index funds, they are mighty cheap to own. You can dial up or down your exposure to risk by choosing from a small range of options, from income to growth.

If you want something a touch more sophisticated, consider building a balanced portfolio of ETFs. That way, you get the low cost of index ETFs and the risk-adjusted return commonly experienced by pension funds.

Any way you slice it, the key is to lower costs and take on precisely measured amounts of risk. It’s not necessarily about “beating the market” but beating inflation by a wide enough margin while allowing your money to safely compound until you need it, in retirement.