Everyone seems to be looking for the silver bullet when it comes to investing. Index funds are boring, so surely there is more upside to be found in artificial intelligence or small-caps or some other yet-to-be-discovered opportunity that generates record-breaking returns. Right?
Not according to Burt Malkiel, the author of the bestselling investment bible A random walk down Wall Street He says trying to find an alternative solution to index funds is one of the biggest mistakes the average investor makes. Even those who do it professionally tend to underperform the broader market.
It may seem surprising that optimism about index funds is considered an unusual proposition, but there’s been a lot of talk lately about the so-called “index fund bust” — or the fact that the Magnificent Seven tech stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) account for about 20% of the S&P 500’s total value and make up much of the year’s gains. But Malkiel, who is the chief investment officer at Wealthfront, says low-cost funds are still the best bet for most investors. Rather than getting caught up in sector selection or trying to read the tea signals about which AI company will one day rule them all, stick to the basics, he says.
“Investing is very simple,” says Malkiel Fortune“To the extent that their income comes from stocks, the primary asset they should have is a broad-based index fund.”
Here are three more mistakes he warns ordinary investors to avoid.
1. Calculate the right moment to enter the market
Okay, this is obvious, but research shows that time and again, investors accumulate money when markets are rising and withdraw it when they are falling. That is exactly the opposite of the ideal investment strategy.
Of course, it’s nearly impossible for even professional investors to consistently time the market (buying low and selling high). That’s why Malkiel and virtually all other investment experts recommend a strategy called dollar-cost averaging, which involves investing money consistently each month regardless of what’s happening in the market. In this strategy, investors buy regardless of what’s happening in the market; over time, the highs and lows more or less balance out.
“Putting a little money from each paycheck into an investment program, not panicking when there is a financial crisis or some international event that terrifies you, just keeping on doing it, has many benefits,” he says. “The long-term way to build wealth is to just keep going.”
If you have a retirement account at work (and don’t stop contributing when the market falters), then you’re already dollar-cost averaging. But it’s a good strategy regardless of which investment account you’re using.
2. Not taking advantage of tax-advantaged accounts
Another big mistake is not making efficient use of tax-advantaged investment accounts. There are two main types that the average investor is faced with when it comes to retirement savings: tax-deferred accounts, such as 401(k)s and IRAs, and post-tax accounts, such as Roth IRAs (or Roth 401(k)s in some circumstances).
A tax-deferred account allows investors to contribute pre-tax income, which gives them a benefit now. When they withdraw money in retirement, they pay taxes then. On the other hand, investors contribute money that has already been taxed to a Roth IRA. When distributions are made in retirement, the growth is not taxed again. Malkiel is especially bullish on Roth IRAs, particularly for younger investors.
“It’s a way for returns to be offset tax-free,” he says. “Not taking advantage of some of these tax-advantaged retirement plans is an even bigger mistake than thinking you’re smart enough to predict the market.”
The good news is that many young people are already investing money through Roth IRAs. In fact, the percentage of households headed by a 20-something investing in a Roth nearly tripled between 2016 and 2022, according to U.S. Federal Reserve data analyzed by the Center on Retirement Research (CRR) at Boston College.
3. Don’t invest at all
Ultimately, Malkiel says the biggest mistake is not investing at all. While he understands that many Americans have to juggle countless financial priorities, he hopes more people will start to see the benefit of investing money for retirement sooner rather than later.
Malkiel points to Starbucks, the much-maligned coffee shop, as an example of where people can find the money. No, he’s not saying to cut it out entirely — “I don’t dislike Starbucks, I go there myself,” he says — but he does say that making substitutions a few days a week (whether it’s takeout coffee or some other common expense) can make a difference.
Think of it this way, he says: A $10 breakfast could turn into $50 in the future thanks to compounding returns. Malkiel isn’t advocating never to indulge in a little treat, but he does say that everyone has to make some kind of sacrifice in order to reap bigger gains in the future. You can have anything, but not everything.
“A dollar today means several dollars less in retirement,” he says.
And spending $10 a day on a mediocre cup of coffee and a croissant could also mean losing $20 right away, if you have a 401(k) contribution at work that you’ve been neglecting. That’s a loss of 100% return.
