Today, the individual investor has more access to information and the ability to trade on that information than ever before. Company products, business models, profit margins, leadership teams, and supply chains can all be learned from a laptop. Without any specific license or degree, but with access to the internet, you can learn everything you need to develop an investment opinion on a company. This goes hand in hand with the fact that mobile trading and investing has become commonplace post-pandemic. Compared to other moments in history, this seems an ideal time to pick stocks and achieve long-term wealth. So why not give it a shot?
Keep in mind a few things.
1. You need sleep. The public markets don’t. Stock picking requires time and mindshare that most people don’t have or don’t want to spend. You have a job, family, hobbies, and numerous other things that may be more important than monitoring different stock tickers.
2. Warren Buffett is famous for a reason. He is in the top .0001% of wealth because he is in the top .0001% of stock-picking success. With the exception of Warren, most people who dedicate the time to pick stocks will underperform. Why? Because there are thousands of publicly traded companies. Most of them lose value. Only a few of them generate meaningful long-term returns.
3. Making the right picks doesn’t always feel right. The top performing stocks over the 40-year period from 1985 to 2024 had a median max drawdown of 72%. That means at least half of the stocks that ended up doing the best by the end of the period lost almost three quarters of their value before rising again.
4. The professional stock-pickers (read: active fund managers, hedge funds, and big banks) have more money and time to spend, more research tools to utilize, and more experience to rely on – and yet, the majority of them still underperform the market.
Picking winning stocks is hard, even with unparalleled access to information. It’s especially difficult to do consistently over a lifetime. So, as an individual investor, how can you effectively invest for the long-term, helping you build wealth, if you don’t want the risk or stress of stock picking?
Enter the index fund.
An index is a list of publicly traded companies. It’s a measurement tool that tracks a specific corner of the stock market. The most common is the S&P 500, which tracks the performance of 500 of the largest companies in the U.S. In comparison, the FTSE Developed All-Cap ex US index tracks the performance of companies across international markets. Members include parts of Western Europe, Japan, Canada, and Australia.
An index fund is an investment vehicle that holds a basket of stocks identical to a certain index. Index funds are usually structured as exchange-traded funds (ETFs). An S&P 500 index ETF allows an investor to own the 500 stocks in that index by only purchasing one thing. Similarly, a FTSE Developed All-Cap ex US index ETF allows an investor to own stocks across a wide range of countries via a single holding.
The beauty is that an index fund does the work of selecting stocks to own for the long-term so you don’t have to.
All indexes have certain membership criteria that companies must meet in order to be included. Here are some requirements companies must meet to be included in the S&P 500 and what they tell the investor.
- Market capitalization of at least $22.7 billion. Investor takeaway? A large market cap represents widespread ownership of a company’s stock, which contributes to the long-term stability of the company.
- Satisfy the U.S. Securities Exchange Act’s periodic reporting obligations. Investor takeaway? Publishing reports such as Form 10-Ks and 10-Qs disclose important information about the company and provide transparency to the public.
- A high level of liquidity, based on how frequently shares are bought and sold. Investor takeaway? High liquidity gives investors the ability to turn their shares into cash when needed.
- Positive net income from the most recent quarter and the sum of the most recent four consecutive quarters. Investor takeaway? Profitable companies are healthy companies.
The FTSE Developed All-Cap ex US index has similar requirements as the S&P 500, looking at metrics like sales, cash flow, and book value (which equals a company’s assets in excess of their liabilities) that demonstrate a business’ health. FTSE states that “by anchoring the index to economic measures, the fundamental index approach contra-trades against the market’s constantly changing views, expectations, fads, bubbles, and crashes.” In other words, the index doesn’t chase fast moving and unpredictable market trends. Instead, it is comprised of businesses that are fundamentally sound.
Companies that are widely owned, share information with investors, consistently turn a profit, and have healthy cash flow are generally those you’ll want to own for the long run. Why spend extra time, energy, and stress deciding which stocks to buy when the index is investable and does all of that work for you?
Index funds take the guesswork out of investing. Their investment “picks” are constrained by the academic rules of the index they choose to replicate. When investing with the goal of building wealth over decades, it’s necessary to make prudent investment decisions with discipline and consistency.
Index funds allow you to do exactly that.
Peter Kulseth, Investment Advisor
Peter is a native of San Juan Island. After graduating from Gonzaga University he moved to Seattle where he joined Bear Mountain. He cares deeply for his clients, helping them navigate their relationship with finances and everything that comes with it. Away from his desk he enjoys the fresh air of the Pacific Northwest by any means necessary – skiing, camping, playing basketball, and golfing.