It’s no surprise that Joel Greenblatt’s book The Little Book that Beats the Market became a best-seller. Not only is the book an easy-to-read, enjoyable introduction to Value Investing, but it also gives compelling evidence that it is not just possible but quite probable that the average retail investor will outperform the S&P 500 index over time by following the relatively simple strategy detailed in the book.
The book sure captured my imagination, but before I embarked on the strategy myself I at least tried to find a few testimonials. By the time I’d read the book it had been out for about ten years. Surely there must be some people out there describing how the strategy has worked so far for them, right? Erm, no. Or at least not many. I found plenty of people willing to put down the strategy. Heck, those Bogleheads hate any strategy other than buying index funds. But most people writing for or against the strategy were mainly basing their arguments on whether or not they believed The Book, not how Formula Investing has actually worked out for them.
There are several reasons why most investors will not follow through with the strategy despite believing whole-heatedly in it, and those reasons will be the subject of several posts. One such reason deals with the effect that fees have on a small portfolio. I did find some discussion of Formula Investing in various online forums, and there’s often some poor soul asking, “I have $10,000 to invest – should I do the strategy?” Unfortunately, my answer to such would-be Formula Investors is: No.
Following the Formula Investing strategy, you know you are going to complete 60 transactions per year – 30 when you buy each stock, and 30 when you sell. If you use an online brokerage account such as Scottrade that charges $7 per trade your fees will total $420 per year. These fees put the expense ratio of a $60,000 Formula Investing portfolio at .7%, or seven-tenths of one per-cent. That’s not horrible – according to Morningstar, the average Mutual fund expense ratio is 1.25% – but I wouldn’t want to pay much more than that. If you go with Trade King, an online brokerage account that charges only $4.95 per trade, you can keep expenses under 1% with a portfolio as low as $30,000. But I wouldn’t recommend the strategy for a portfolio any smaller than that. As you can see in this PDF report from the Securities and Exchange Commission, fees matter a lot. To justify paying fees higher than a low-cost index fund, you better believe that your strategy is going to beat the market, or at least provide you with relatively secure income, such as in a dividend investing strategy.
That’s why if someone approaches me at a cocktail party and asks for advice on getting started investing in the stock market I would most likely direct them to Vanguard’s VTSAX index fund, especially if they had a long time frame and wanted to invest a little bit each month. Each share of the VTSAX gives one exposure to thousands of stocks over every sector of the US stock market and the fees are very low (about one-twentieth of one percent annually with no transaction fees).
As compelling as Formula Investing sounds, if you’re really going to follow the strategy you should have a pretty good chunk of money set aside to invest. Otherwise, diving into the strategy before you’re ready could mean being eaten alive by fees.
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