(Fortune) - Everyone seems to be looking for the magic bullet when it comes to investing. Index funds are boring, so surely there's more upside to be found in AI or small-caps or some other yet-to-be-discovered opportunity that will yield unprecedented returns. Right?
Not according to Burt Malkiel. The author of the bestselling investing bible A Random Walk Down Wall Street says trying to find a work-around for index funds is one of the biggest mistakes the average investor makes. Even those who do it professionally tend to underperform the broader market.
That being bullish on index funds is considered an unusual proposition may seem surprising. But much has been made lately about the so-called narrowing of index funds, or the fact that the Magnificent Seven tech stocks—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—account for around 20% of the S&P 500's total value and make up much of the gains for the year. But Malkiel, who is Wealthfront's chief investment officer, says the 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 leaves on which artificial intelligence company will one day rule them all, stick with the basics, he says.
"Investing is very simple," Malkiel tells Fortune. "To the extent that their income is stocks, the main asset they should be holding is a broad-based index fund."
Here are three other mistakes he warns everyday investors to avoid.
1. Timing the market
Okay, this is an obvious one. Still, research shows that time and again, investors pile money in when markets are riding high, and pull out when they are sinking. That's the exact opposite of the ideal investment strategy.
Of course, it's almost impossible for even professional investors to consistently time the market effectively (by buying low and selling high). So Malkiel and pretty much every other investing expert recommends a strategy called dollar-cost averaging, meaning consistently investing money each month regardless of what the market is doing. In this strategy, investors buy regardless of what the market is doing; over time, the highs and lows more or less even out.
"Putting a little money from each paycheck into an investment program, not getting scared when there is a financial crisis or there’s some international event that terrifies you, just keep on doing it—that has such benefits," he says. "The long-run way to build wealth is to just keep on going."
If you have a retirement account at work (and don't stop your contributions when the market gets shaky), then you're already dollar-cost averaging. But it's a good strategy regardless of the investing account you're using.
2. Not taking advantage of tax-advantaged accounts
Another big mistake: not making efficient use of tax-advantaged investment accounts. There are two main types that the average investor deals with when it comes to retirement savings: tax-deferred accounts, like a 401(k) and IRA, and post-tax accounts, like a Roth IRA (or Roth 401(k) in some circumstances).
A tax-deferred account lets investors contribute pretax income, giving them a benefit now. When they withdraw money in retirement, they pay taxes then. On the flip side, investors contribute money that has already been taxed to a Roth IRA. When distributions are taken in retirement, the growth is not taxed again. Malkiel is especially bullish on Roth IRAs, particularly for younger investors.
"This is a way of having your returns compound without tax," he says. "Not taking advantage of some of these tax-advantaged retirement plans, I would say that’s an even bigger mistake than thinking you’re so smart that you can time the market."
The good news is that many young people are already investing money via Roth IRAs. In fact, the percentage of households headed by a twentysomething investing in a Roth almost tripled from 2016 to 2022, according to data from the U.S. Federal Reserve analyzed by Boston College’s Center for Retirement Research (CRR).
3. Not investing at all
Finally, Malkiel says the biggest mistake is not investing at all. While he understands that many Americans are juggling countless financial priorities, he hopes more people will start to see the benefit of investing money for retirement sooner rather than later.
Malkiel references the oft-maligned Starbucks coffee as an example of where people might find the money. No, he's not saying to skip it completely—“I’m not down on Starbucks, I go there myself," he says—but he is saying making substitutions a few days a week (whether for coffee to go or some other common expenditure) can make a difference.
Think of it this way, he says: a $10 breakfast could become $50 down the line thanks to compounding returns. Malkiel isn't advocating for never having a little treat, but he is saying everyone has to make some kind of sacrifice for a larger future gain. 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 cup of mediocre coffee and a croissant could also mean losing out on $20 immediately, if you have a workplace 401(k) match that you've been neglecting. That's the loss of a 100% return.
By Alicia Adamczyk
