That "Low-Cost" ETF Strategy Will Doom You to Low Returns

"Oh, just buy a low-cost index fund or an exchange-traded fund, and then sit back and relax - it's all be gonna wonderful."

That's the current mantra from a large portion of Wall Street right now, and it has become pretty much accepted as gospel.

On the surface, at least, it appears to be solid advice. But like all Wall Street advice, there are some major flaws.

Fatal flaws, I'd say. Let's look at two investors...

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Here's What's Wrong with the Passive "Strategy"

The "index and relax" experience has been very different for someone who started in 1999, as opposed to someone who began in March of 2008. What I mean is timing plays a huge role in the success of indexing. It's tough to really grow your wealth at a less than 4% annual return, which is what investors have earned in the last 20 years.

What's worse, you have to hold through good times and bad.

Investors who tried to do this have had to withstand two ~50% drops in value - and lots of scares along the way.

Now, I know a lot of people who think they are that tough, but that's not reality. In my experience, even the toughest-talking Warren Buffett wannabe is hitting the "Sell" button at a fevered pace when the markets are collapsing.

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On the other hand, it's really hard when markets soar 25 to 30% or more not to cash in and tell yourself you can buy back in lower. You won't; most people are just not wired that way.

That's a good thing...

Some Things Are Cheap for a Good Reason

Of course, we also have to address that fact that costs may not be as low as "advertised," or as low as you might think.

The management fee might very well be low, but if you are trading in and out several times a year based on your political opinion, squiggly lines on a chart, or what side of the bed you got up on a particular day, you must - repeat, must - add those commissions to the costs.

Those "frictional" costs add up even if you are trading at a low-cost discount broker.

I also run across far too many people that think that because some exchange-traded funds are cheap, then they all are.

That's not the case at all.

When I look across the universe of ETFs, I see funds with expense ratios of 2% and even 3% a year.

So, if we are now sliding into a low-return environment for the broader market indexes - and by all indications we are - then it is going to be damn hard to get rich when the fund manager is making almost as much as you are!

It's not true of index funds either.

Fees on plain old open-ended index mutual funds range from 0% at Fidelity to over 2% at Rydex funds. Blackrock sells an S&P 500 fund with an expense ratio over 1% and will be offering an index ETF with a ratio of just .04%.

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If you don't read the prospectus and do your homework, a good deal of your long-term profits will end up in the hands of Wall Street.

For index investing, you have to work to find the right fund with low fees and hold it no matter what happens.

In my 30-odd years in and around the markets, I have learned that most people are busy living their lives; they don't have the time to do all the homework. And the human brain has a powerful fight-or-flight instinct... that (as often as 85% of the time, studies show) will lead us to buy and sell at precisely the wrong time.

So, what do we do with our money?

Even John Bogle, index investing's biggest fan, is telling us that the returns over the next 10 years are going to be pretty poor. He estimates that U.S. stocks might return about 4% over the next decade.

The folks at GMO Asset Management are suggesting that the seven-year returns for large-cap U.S. stocks will be less than zero. A look at history tells us that when the 10-year P/E ratio of the market is as high as it is right now, returns are also somewhere right around zero.

I have talked about this in the past, but the truth is I should probably be talking about it a lot more than I have been.

To make the kind of money that allows you to live your dreams, you simply cannot do what everyone else does.

The alternative: Look at the people who have actually gotten rich in the stock market - the Klarmans, the Icahns, the Paulsons, the Schwartzmans, the Buffetts - and do what they did.

What did they do? They bought great businesses at great prices and owned them for a long time.

You don't want exciting high-flying companies that can flame out. You want solid companies that produce piles of cash that can be used to grow the business, pay dividends, and buy back stock - all of which puts money in your pocket.

Trust me - It's much easier to hold onto a great company through good times and bad than it is to own the whole market through an entire cycle.

The trend is clear. Everyone is buying indexes and passive ETFs.

Don't be everyone.

Be a Heatseeker: Never Buy a Losing Stock Again

Tim Melvin has developed a strategy that eliminates stock losses and allows him to close out positions with 300%, 500%, even 787% upside - an undefeated track record. How does he do it? Find out right here before he takes this video down forever!

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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