Index Funds - How to Beat the Stock Experts
Believe it or not, you can do this easily, simply by investing in Index funds. This is the most well-kept secret in money management. Why? Well, it’s because no one on Wall Street makes any real money off Index funds, regardless of whether they are the some of the most appropriate investments for most people.
So what are they? Well, first I should explain that there are two types of mutual funds: index funds and actively-managed funds. Actively-managed index funds employ teams of expensive analysts and portfolio managers to pick and choose what to buy and sell. In other words, they actively make decisions on what to invest in. In contrast, an index fund builds its portfolio by simply buying all the securities in a particular index -- not just a few – thereby reproducing the performance of the entire index. You may have heard of the S&P 500 Index, well, there are index funds that mimic it and dozens of other indexes.
Index investing has three big advantages over active investing.
Index Funds perform better than active funds
This has been established through numerous studies. The more studies I read, the more overwhelming the evidence looks that no manager can beat the market in the long run. In the short run a few of them will do it through sheer luck, and a few lucky investors will have chosen the lucky managers… But you have to ask yourself: do you feel lucky enough to pick winning funds? I’ve been in the industry for nearly two decades and I’ve seen a lot of people try and most fail to do this.
Index funds are much cheaper to run than active funds
Eliminate those analysts' salaries, expensive research and marketing machines and an index fund can cut its costs tremendously -- and those savings can be passed along to investors – they keep more of the pie.
Think of investing as a pie: if someone takes a big slice, that leaves less for the next person and so on - if someone wins, someone else loses. The loser is always the individual investor. Actively-managed funds are simply expensive to run.
How do you think Wall Street manages to pay itself such huge salaries and bonuses? After subtracting the costs of all those management fees, brokerage commissions, sales loads, advertising costs, and operating costs, the returns of investors as a group MUST, and WILL, and DO fall short of the market return by an amount equal to the total of all these costs. The more the manager takes, the less you will make.
And if you don’t think you are paying a ton through your mutual funds, read my blog article “Mutual Funds - What They Won't Tell You About the Fine Print” sitting down.
So just how much are you paying in an actively managed stock fund and does it really matter over the long term? I will spare you the math, but the “all-in” costs of stock fund ownership can be as much as 3% to 3.5% per year! And the irony is you aren’t getting what you paid for.
For example, say you have $10,000 to invest and your choice is between an active managed fund and an index fund. I’ll be generous (to the active managed fund) and say that both funds perform the same. Let’s assume that the stock market will return an average of 9% for 20 years.
The index fund will be worth $56,044. The actively managed stock fund (after 3% costs) will be worth $32,071. Which one do you want to invest in?
Index funds hit you with fewer capital gains taxes
And finally actively-managed funds are remarkably tax-inefficient. This is a result of the short-term focus of portfolio manager, usually frenetically trading securities. In fact, industry-wide, the average stock is held for an average of just 12 months. All this buying and selling generates capital gains taxes that get passed on to mutual fund shareholders. So much for the long-term perspective…
The index fund follows precisely the opposite tact – buying and holding forever, or until it drops out of the index. But that doesn’t happen very frequently at all.
Most sophisticated investors use index funds already. The simple index fund solution has been adopted as an investment strategy for many of the nation’s pension plans operated by giant corporations and state and local governments. In fact, one of the largest of them all, the Federal Thrift Savings Plan ($197.3 billion in assets as of January 2009), uses index funds as their predominant strategy.
What is the appropriate mix of mutual funds vs individual stocks? I have historically invested more actively in stocks and in recent years have gotten slammed. Mutual funds are therefore appealing, but should I also diversify and invest in some blue chip companies?
Great question. I hear this a lot. I would say that if you don't have the time to track individual companies, put your entire equity (stock) allocation into an index fund.
Mutual funds have a number of advantages over buying individual stocks. This is especially true if you don't have the time and resources to track individual stocks. Owning stocks means that you have to constantly be up to date with anything surrounding the individual stock or it's industry - basically anything that can affect its price and valuation. Do you have the time (or the expertise) to properly evaluate a company? Remember, good companies don't necessarily make good stocks either. And that's because the price of the company stock (or its valuation) can be too high compared to it's earning potential.
The biggest advantage mutual funds have over owning individual stocks for most investors is diversification. In other words, owning all the companies in the market is like not putting all your eggs in one basket. To understand this, we have to understand the sources of risk in investing.
There are two primary types of risk in owning individual stocks: stock-specific and market risks. You can't get away from market risk, but stock-specific can be virtually eliminated by owning a diversified portfolio of the stocks like in a mutual fund. The more diverse your portfolio the better.
Regarding investing in "blue chip" companies, the S&P 500 Index Fund also has most of the "blue chip" companies in it already.