Vanguard Total Stock Market ETF (VTI) seems ideal for small, long term investors.
It's difficult being a little guy in the stock market. You can't afford your own research department, real brokers don't want to talk to you because your portfolio is too small, and if you try to diversify by buying single stocks your return will get crushed by transaction costs.
Exchange traded funds are an interesting way to get instant diversification, much like a mutual fund only with lower expense ratios, typically less active turnover resulting in better tax consequences, and typically less limitations like "minimum initial investment."
As ETF's go, VTI is interesting because it basically represents the return of the entire US stock market and has a very low expense ratio. It's current holdings include 3,713 different stocks. Pretty tough to beat that level of diversification with your own individual stock portfolio, huh?
If you are a believer in efficient markets, or you've researched the subject at all, you'll know that in the long term, VERY FEW fund managers manage to beat the market return. Obviously there are a few exceptions, such as Warren Buffet, but for the most part every mutual fund fails to beat the market over the long term.
Active Mutual Funds vs. VTI
According to this article on Fool.com, the average actively managed mutual fund has a 1.5% expense ratio. In comparison, VTI has an expense ratio of 0.07%.
As an example, say you are 30 years away from retirement and currently have $0 saved. You are going to invest $4000 a year until you retire. You can either invest in VTI or an actively traded mutual fund. The market over that time will return 12.2%. VTI has an expense ratio of 0.07% while the mutual fund has an expense ratio of 1.5%. It costs $7 a year to buy into VTI (scottrade), but nothing to buy into the mutual fund. Both funds return the same amount. Which is the better choice?
VTI
Total Invested: $124,000
Ending Account Balance: $1,126,018
Gain on Investment: $1,002,018
Total Expenses: $702
Total Transaction Costs: $217 + $7 to sell = $224
Total Investing Expense: $926
Investing Expense as Percentage of Gain: 0.092%
Mutual Fund
Total Invested: $124,000
Ending Account Balance: $979,597
Gain on Investment: $855,597
Total Expenses: $14,694
Total Transaction Costs: $0
Total Investing Expense: $14,694
Investing Expense as Percentage of Gain: 1.72%
And this doesn't even take into account the tax differences from the active trading of the mutual fund versus the passive trading of the ETF. When a mutual fund manager buys and sells stocks in the short term, they can pass through from the mutual fund in the form of short term gains - which are taxed as ordinary income. Unless you can offset these gains somehow with losses, it can prove to be VERY expensive. Currently, long term gains are taxed at 15% (5% for lower tax brackets). Short term gains are taxed at your normal tax bracket rate - say 25%. Even if, through short term buying and selling, the fund manager is able to outperform the market, the tax consequences may result in your return on investment being lower.
Conclusion
Everyone is different. They want to save different amounts, have different appetites for risk, want to retire living different lifestyles, etc. I don't recommend any one strategy. If you can, the best advice is to consult a professional and do your homework. However, I can say that most likely given the research I have seen, a mutual fund will not outperform the market and VTI is one of the cheapest ways to match market returns and be diversified.
