How to avoid another Enron

Last time we talked about stock ownership and how it’s different from gambling, but that risk still remains.

In particular, the risk that your companies may go out of business, leaving you with stock worth little more than used lotto tickets.

This is a very real risk. Fortunately there is a reasonably safe solution. But first, lets push away—once and for all—the dream that you will find the next Microsoft by investing in individual stocks.

Prepare to be disabused

Picking a big winner is highly unlikely. Even the experts have trouble selecting future big earners, at least without also selecting plenty of big losers as well.

Not only do you need to find the right businesses, but you must find them at the right time as well—a near impossible task for the individual investor at home.

You also need to know the best time to sell a winner, so you can buy the next fast grower at the right price. Company growth and stock growth slows over time, so one would need to be extremely flexible, and right. All of the time.

Finally, hidden minefields must be avoided. Stock owners always face the small, but real risk of losing everything when a company suddenly goes bankrupt.

Sound easy? Fortunately, there is an easier way to own successful stocks.

A safer, more reliable way to own stocks

So how does the average investor avoid these pitfalls, while still enjoying any upturns in the stock market? Index funds. Index funds allow investors to own hundreds of stocks, spreading their risk across the entire market.

In fact, a mutual funds’ success can only be measured by comparing it to the relevant stock market index. While some funds manage to beat their indices, few do so consistently. (Indices is simply a fancy financial term for “indexes.”)

Simply investing in an index fund will allow you to beat up to 85% of the actively managed funds out there.

This is possible because:

• Index funds have fewer transaction costs (constantly buying and selling incurs a lot of stock trading fees). Lowered transaction costs translate into lower expense ratios for investors, leaving thousands of dollars where they belong—with you.
• Index funds protect you from incorrectly timing the market. Many of the biggest stock market gains are limited to a short period of time. If you aren’t invested or if you own the wrong stocks you would miss out on huge gains.
• Index funds are protected from management risk. Some managers beat their relevant indices, some of the time. However, there is a risk that they will retire, make a big mistake, or some other surprise will affect your return. With an index fund, you always know where your money is invested.

To learn more about investing with index funds, check out the reliable but accessible book: The Bogleheads’ Guide to Investing (sample chapter available).

Photo by James