This is a guest post from Mike Piper, who blogs at The Oblivious Investor, where he reminds readers that investing doesn’t have to be complicated or stressful. Mike is a long-time GRS reader and the author of Investing Made Simple.
Like many other investors, J.D. and I are fans of taking the slow, sure path to wealth. We invest much of our money in index funds. An index fund is a low-maintenance, low-cost mutual fund designed to follow the price fluctuations of a broader index, such as the S&P 500 or the Wilshire 5000. They’re boring investments, but they work. (If you’re investing for the excitement, you’re doing it for the wrong reason.)
Because of their low costs, index funds have been shown over and over to dominate the majority of their competition. Yet many investors shy away from index funds with the reasoning that “the stock market is too risky for me.”
People seem to think that index funds are simply mutual funds that track the U.S. stock market. And that’s not particularly surprising given that S&P 500 index funds are:
- the largest index funds,
- the index funds mentioned most frequently by the media, and
- the index funds most likely to show up as an choice in your 401(k).
But there are all kinds of index funds aside from those that track the S&P 500. There are bond index funds, real estate index funds, commodities index funds, international stock index funds, and so on.
In other words, you can create a thoroughly diversified portfolio using nothing but index funds.
In fact, I’d suggest doing exactly that. By created a diversified, all-index fund portfolio, you’ll achieve a list of benefits relative to other types of portfolios.
Lower Risk
Which sounds safer: Having the stock portion of your portfolio invested in 10 different companies, or having the stock portion of your portfolio invested in several thousand companies from more than 10 different countries? I know some people disagree, but to me it’s a no-brainer.
By constructing your portfolio from index funds, you’ll achieve far greater diversification (and therefore be exposed to less risk) than you would if you constructed your portfolio from individual stocks and bonds.
Lower Costs
Both common sense and historical data tell us that one of the best ways to improve investment returns is to reduce costs. Conveniently, index funds carry significantly lower costs than actively managed mutual funds. For example:
- Vanguard’s Total Bond Market Index Fund has an expense ratio of 0.22%. That’s less than one-fourth of the average expense ratio among bond funds (1.04%, according to Morningstar’s Fund Screener tool).
- Vanguard’s REIT Index Fund has an expense ratio of 0.26%, or less than one-fifth that of the average real estate fund (1.45%).
It’s quite possible that you could cut your total costs by 1% or more. And while 1% per year may not sound like much, it can really add up over an extended period.
Lower Taxes
Index funds have much lower portfolio turnover than other mutual funds. (That is, they buy and sell investments within their portfolios far less frequently than actively managed funds do.) This makes them more tax efficient than other mutual funds for two reasons:
- The capital gains they distribute are primarily long-term in nature (and thereby taxed at a lower rate than short-term capital gains), and
- Their capital gains distributions are minimized, meaning that you get to defer a significant portion of taxes until you sell the fund.
Added Bonus:
You’ll understand what you own. With an actively managed mutual fund, you never know exactly what the fund manager is investing in. With index funds, it’s all out in the open.
Do you (like both me and J.D.) have a portfolio made up primarily of index funds? If not, why? Is there a particular concern that’s holding you back?
This article is about Investing
SEARCH FOR RECENT ARTICLES
My mistake I noted that and was going to edit my comment but figured it be best to write a new one.
I agree with your statement but note that you wrote average actively managed dollar. This average depends on the population that the average is taken from. If its the entire market then yes its likely because most people are stupid with money. There are still a number of individual investors who actively manage their funds and are quite bad at it. But Take today’s most critically acclaimed managers as a group of 10. I don’t have the data but I’m willing to bet their average spanks the market.
loading....
“This average depends on the population that the average is taken from.”
Absolutely. I speak only in regard to the entire market.
“If its the entire market then yes its likely because most people are stupid with money.”
Actually, it’s more than likely. It’s certain. And it doesn’t depend on any stupidity other than the high costs of active investing. To quote Sharpe:
——
If “active” and “passive” management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar
These assertions will hold for any time period.
——
loading....
James: “There are still a number of individual investors who actively manage their funds and are quite bad at it.”
Sure, but they are the extreme minority of the market. They represent a tiny sliver of the capital comprising the markets. They are not who you are trading with. Also, I’m sure they don’t think they are “quite bad” at it – they probably think YOU are “quite bad” at it. Who’s to say who’s right?
James: “But Take today’s most critically acclaimed managers as a group of 10. I don’t have the data but I’m willing to bet their average spanks the market.”
But James, what makes them “critically acclaimed?” Their performance, right? Out of a pool of thousands and thousands of mutual fund managers, 10 emerged who have consistently beaten the market average for 10 years running or whatever. Right?
But here’s the rub, James. Were they critically acclaimed BEFORE they outperformed the market, or AFTER?
Of course, it was after. So the problem is, how do we identify these superstar fund managers before they outperform the market? Identifying a fund manager who has beaten the market for 10 years in a row is of no use to you at all. You cannot go back in time and invest with them at the beginning of the run.
Those 10 “critically acclaimed” managers looked exactly like the thousands of other managers before they had their stellar/lucky run.
If you take 1024 people and have them flip a coin, half will come up heads. If you do it again, you’ll be left with 256 people who flipped heads twice in a row. After 10 rounds of this, you’ll be left with one guy who flipped heads 10 times in a row. Is he the best coin-flipper in the world, or just a statistical inevitability? How much would you be willing to bet that he can flip heads if he flips his coin one more time? I mean, after all, he just did it 10 times in a row! It’s practically a sure thing, right? He’s a critically-acclaimed coin flipper.
loading....
The costs for an indexed dollar don’t just disappear. They are low to each person as a result of economies of scale. However, the brokerage that is making these trades for cheap pays serious fees to hold a seat on these exchanges as well as other capital expenses. Therefore, the actively managed dollar barely loses to the indexed dollar and in fact the individuals who are putting money into the index, it is their low fees that are paying down most of the indexed transaction costs. Its the brokerage that is capitalizing on these costs not the investor. They retain the majority of the profit that is created by the economies of scale, it isn’t just handed back to individual investors. There will always be trade fees and account fees and these costs are paid by everyone and they far exceed the value of any index fund expense ratios.
The resulting minimal difference doesn’t warrant giving up my ability to actively manage my portfolio in my opinion. But this comes down to personal preference.
loading....
“So the problem is, how do we identify these superstar fund managers before they outperform the market?”
You can’t. But I’m not advising people to use mutual funds. You can never tell what another person will do with your money your best bet is to trust yourself. I’m advising that people can outperform the market individually if they try and it isn’t based completely on luck.
Your analogy of a coin toss doesn’t correspond with investing. Flipping a coin has a completely random distribution however stocks are not equally weighted. For example, either way a coin flips its value is 1 or 0. A coin can either be heads or tails. Stocks flip in degrees of 1 or 0. A stock can rise or fall but it does so at varying degrees such as 3% or 40%. Therefore, any investor who has information affecting the variables that affect the flip will outperform those who do not over the long run. While this information is derived from educated estimates this does not make it invalid.
The Media tricks people by saying that “no fund manager can consistently beat the market.” Well of course nobody can do it every single year in and year out, but this detail is left out. It corresponds with the flip of a coin. What they don’t acknowledge is that the long term compounded returns of many of these funds smash the long term compounded returns of the corresponding index. Long term returns are affected by a larger number of variables than 1 year returns. It isn’t luck that these managers long term returns kill the markets.
Other individuals can perform similarly with the proper research. I believe someone also mentioned that individual investors cant compete with these larger professional investors due to the amount of information they have. Technically they have no information that the public doesn’t have access to. Otherwise its moved into insider trading. They may be on speaking terms with management but management cannot give them any significant data that isn’t also shared with the public.
I don’t think I can type anymore its impossible to keep up lol
loading....
@Kevin you say
“Bogle points out that the market is a closed system. That is, we’re all just trading with each other. There isn’t some magical, faceless buyer/seller out there we can all interact with and somehow all come out ahead. It’s just a big auction, selling the same things to each other, back and forth, over and over. Some people will come out ahead, and some will come out behind.”
This is just flat out wrong. Value (read: goods and services) are created. They are not a fixed resource. New IPOs are made often, companies are creating new products and making available new services all the time.
A trade is a voluntary contract very often made to mutual advantage. It certainly does not require that one side will win and one side will lose. The market is most definitely not a closed system. You seem to have identified the difference between the mentality of a trader, and that of an investor.
loading....
Russ good point.
loading....
To those suggesting Target Date Funds as their investment of choice:
These are often TARGET DEATH Funds,not TARGET RETIREMENT funds. There is a big change coming in the industry due to a misconception about these funds. As you approach retirement, you should be more heavily invested in bonds than stocks. In the recent downturn in 2008, you had many many 2010 Target Date funds loose a considerable amount of money. This is completely unacceptable for a fund that bills itself as a “complete solution” for investors. Plus, the fees that you find on a lot of these funds are considerably higher than a self-made comparable fund.
Don’t just take a salesman’s word for it when you are investing, make sure you do your homework!
loading....
Is this article about retirement a.k.a 401k or 403b? I want to research more on investing after-tax money as well. I have brokerage account on Fidelity and TDAmeritrade. Let’s say I have $500 to invest monthly. With hypothetical 0.5% fee and $10 trading fee, would it be worth it to buy ETF or index funds? Each month they will charge me the trading fee. Isn’t a regular mutual fund be cheaper in terms of fee then? Thanks for your enlightenment.
loading....
Meow!
loading....
Hi Martin.
It’s very rare that buying an actively managed mutual fund will have lower costs than buying an index fund.
For example, at Fidelity, their “Spartan” index funds have extremely low costs. (More info here.) To the best of my knowledge, none of their actively managed funds have such low fees.
As to the question of investing in a taxable account, index funds and ETFs are generally (though not always) much more tax efficient than actively managed funds. The reason is that they have lower turnover in their portfolios.
loading....
Me: “So the problem is, how do we identify these superstar fund managers before they outperform the market?”
James: “You can’t. [Y]our best bet is to trust yourself. I’m advising that people can outperform the market individually if they try and it isn’t based completely on luck.”
This is contradictory. You’re saying that with a little effort, I can outperform the market, but it’s impossible to identify which experienced, professional money manager will be able to do the same. Shouldn’t they all be able to do it, if it’s so easy, and they have so much better tools and more experience than me?
Why wouldn’t that money manager just exert the same “little effort” that you’re advocating I apply, and achieve the same result (that is, beating the market consistently)?
Do you see why that doesn’t make sense to me? If an educated, experienced, full-time professional, with access to instant information and trades, is unable to consistently beat the market, then what chance do I have?
Furthermore, if it really were possible, as you say, to outperform the market with a little effort, why doesn’t everyone just do it? And if everyone did, what happens then? We all get to outperform the market?
This comes back to my original point. We cannot all be “above average.” There must be winners and losers. Thus, your safest bet is to simply acknowledge that you are no more likely to beat the market than anyone else, and decidely less likely to beat it than full-time professionals with better tools and information than you. So minimize your expenses, and accept average returns.
loading....
Our family portfolio of stocks and bonds are 95% index funds, with a tiny allotment for managed funds in a 401k. Once this is rolled over (i.e. the job change), we will move 100% to index funds.
I thought it would have been beneficial if you mentioned how index funds outperformed managed funds. I find that this is the most powerful argument for people who argue for managed funds.
loading....
It has always been a bit of a mistery to me why people feel the need to convince others with “anecdotal evidence” that their investment strategy is better than anyone elses. If you are right, then your returns will be your reward or if you are LUCKY you may be rewarded as well. Luck will come into play whether you happen to pick an outperforming fund (among thousands of them out there) or if the market does well overall and you pick an index fund. The thing is that those who pick the managed fund will BELIEVE that they were smart as well and if so more power to them
Those that understand the research done on this subject and do not need to feed their egos know better and will stick with index funds.
loading....
Kevin is giving very good advise based upon published peer-reviewed research as well as some very good books that makes this research more accessible to the average investor, in contrast to some of the Wall Street shills above.
loading....
Perhaps the direction of some of this conversation is focusing too much on the differences between investment products.
The spirit of much of the conversation should encourage more people to take their own finances more seriously, whether or not that means index funds or actively managed funds. I would much rather have 20/20 of my family investing because they all have varying opinions on choices rather than 10/20 because 5 of them are telling the other 5 their choices are ridiculous, and the 10 that don’t invest just don’t want to hear it anymore!
I like reading the comments, but would stress that regardless of product choice, we should all be encouraging our friends/family to be involved in the markets one way or another.
loading....
I hate mutual funds. ETF’s make a lot more sense. You can trade SPY just like a stock, and don’t have to wait until after hours to make (and trust the mutual fund co to fairly complete) your trade.
I like to be active, so I use this timing model to stay trading:
http://www.crystalbull.com/stock-market-timing/CrystalBull-Trading-Indicator-History-chart
Passive investors made NOTHING in the last 10 years!
loading....
morningTrader: “Passive investors made NOTHING in the last 10 years!”
Completely irrelevant. What can you tell me – with absolute certainty – about the next 10 years?
Nothing? That’s what I thought.
loading....
What can you tell me – with absolute certainty – about the next 10 years?
I am not Morning Trader, to whom this question was directed. But I can add some useful input on this question, which I view as a critically important one.
I have a calculator (“The Stock-Return Predictor”) at my site that runs a regression analysis of the historical stock-return data to tell us the most likely 10-year annualized real return for stocks starting from all of the various valuation levels. We cannot identify with precision what the 10-year return will be. But we can identify the range of possibilities that apply at the various valuation levels (the possibilities are dramatically different at different starting-point valuation levels) and assign rough probabilities to the various points on the spectrum of possibilities.
At the prices that applied 10 years back, the most likely 10-year annualized return was a negative 1 percent real.
At today’s prices, the most likely 10-year annualized return is 3 percent real.
In contrast, in 1982 (when stock prices were as insane on the low side as they became in the late 1990s on the high side), the most likely 10-year annualized return was 15 percent real.
Rob
loading....
With regard to investing in individual stocks/bonds yourself:
If you read Benjamin Graham’s spectacular book “The Intelligent Investor”, he lays out a framework for the individual investor striving to beat the market over the long term. However, even this investing giant cautioned that individual investing is more akin to a full-time job than a hobby. For those willing to put in 30 or 40 hours a week, I think that they might have a reasonable expectation of superior long-term performance (though by no means is it guaranteed). Of course, there are plenty of other pursuits that you could spend your time on which may reward you more than stock investing, such as starting your own business, a venture over which I would argue you can exercise a greater degree of control over your success.
Graham, and almost every other investment author I have read, warns repeatedly that a little knowledge can be a dangerous thing when it comes to investing. Many people assume that if they learn the basics, they can spend a few hours a week looking up stocks online, and beat the market. The problem is that like any highly competitive enterprise, your success will depend largely on the amount of work that you put into it. Remember that every stock trade you make involves a purchase from somebody else. If that person has been doing more research than you, they are more likely to be getting the better deal. Keep in mind that over 70% of all stock trades are made by institutional investors, or “the pros”. As William Bernstein says, trading stocks is like playing tennis where you don’t know who is on the other side of the net, and most of the time it is one of the Williams’ sisters.
If you are really willing to put in the time and effort to make investing a second career, you might find success. Or not. Investing, more than many other pursuits, has a very large random component (see Nassim Taleb’s “Fooled by Randomness” for a great explanation of this). And remember, most people are investing to meet certain life goals (retirement, college savings, etc). If you can plan carefully to meet these life goals by investing judiciously in mutual funds, that leaves you more time to spend doing the things that really make life special i.e playing with your kids, spending time with friends, traveling, etc. If you don’t need that extra 1% return that working 10 hours a week on investing might get you, I would recommend against it. The more you can put your portfolio on autopilot, the more time you have to live your life. Money is the means to an end, not the end itself.
loading....
Not sure I really want to get into this debate, because it looks like it’s getting pretty heated, but there is one point I had to re-prove to myself and I’d like to share it.
First off, I think we can agree that the average passive fund will beat the average active fund, simply because the sum of the active funds and the passive funds = the market, and therefore the average passive fund will outperform the average active fund because of lower fees.
I think we can also agree that some active funds do beat the market. If you take out survivorship bias, I would guess that a little less than half of the active funds beat the passive funds in any given year. The problem is, I don’t know which ones will do it next year.
The key question that I was wrestling with is those funds like FAIRX (Russ’s example), which seem to have beaten the market every year for 10 years. It seems too good to be just luck. The truth is, it is pretty hard to rule out luck:
Lets say there is 50% chance of beating the market with a random portfolio of stocks, and you have 5000 different funds. How many would beat the market every year for 10 years? The most likely number of funds is 5000/2^10, or 5. Even though it may seem impossible that a find could beat the market for 10 years in a row due to being lucky, the numbers don’t lie.
Of course it is hard to stay lucky forever. There is the example of Leg Mason (LM) who had an incredible record for several years, but recently has given back years and years of gains.
Anyway, that’s my 2 cents.
loading....
Ezra, you’re just rehashing the thought experiment that was linked on Mike’s website, with different numbers. This doesn’t change the fact that (apart from the model being overly simplified), the assumptions preclude the possibility of an active investor ever being able to beat the market. Using this to prove a point is a tautology, because what you’re trying to prove is already built into your assumptions, therefore the argument is useless.
I think the whole discussion in general is completely missing the point though. It seems to me like the basic disagreement of everyone involved in this argument is not about whether actively managed funds are superior (or can ever be superior) to index funds or not. What’s actually happening is that some of you are risk averse investors, and some of you are not. As a risk averse investor, you’re inclined to settle for expected (average) returns that are somewhat predictable over the long run, instead of maximum returns that are only realized with a certain probability.
Because your risk aversity is fundamentally different, none of you will ever be able to convince the other side that “your” method of investing is better in the long run than “theirs”. It’s a useless debate. Actually, it reminds me of the (famous?) paradoxon about the efficient market hypothesis, which I heard in a class about investment management: assume the market is efficient (i.e. there are no arbitrage opportunities). Why are there no arbitrage opportunities? Because if there were, everybody would be trying to exploit them, making them go away. Now, since there are no arbitrage opportunities anymore, what is going to happen? People will stop looking for them, because it’s obviously a waste of time. But BECAUSE people stop looking for them, arbitrage opportunities can reappear, and be exploited by those who kept looking, making the market inefficient again. Thus begins the cycle from the beginning.
You can twist it or turn it either way, it remains a paradoxon. On the other hand, you guys can throw as many statistics around that support your view as you want to, you’re not changing anything.
If anything at all, the results of this discussion, for a long-term investor, seem to be this:
If you’re risk averse, and you prefer a hands-off approach to investing, index funds are a good choice.
If you’re not risk averse, and you like spending some time on deciding where to put your money, do your own research, and pick stocks based on their long-term potential. This means you THOROUGHLY screen a company before you invest in it (i.e. you read and understand their balance sheet, year end reports, and whatnot, you understand their product, you agree with their management philosophy, etc.). I.e. you really become a STAKEholder, not just a shareholder.
And to stress this part, this means you’re NOT buying their stock because you think it’s undervalued, and it will go up in the future so you can sell your shares for a profit. This means you’re buying the stock for the dividends it’s paying (or going to pay in the future). The stock price basically means nothing to you. It could rise in the future, or it could fall, but you couldn’t care less, because it’s just a number on a piece of paper, made up by arbitrary speculation. The only time it ever means something to you is when you finally sell your stake in the company because you’re retiring, and you’re shifting the money into less volatile investments, like bonds (that, or the company’s fundamentals change drastically, so that your initial evaluations of the company’s long term prospects change).
Ideally, the latter is what an actively managed mutual fund SHOULD do, in which case it’s fine to pay the managers a fee for their effort. However, in recent years, the market has been polluted with a lot of financial instruments that rely on exploiting short-term arbitrage opportunities to make their returns. They’re rarely fully understood by anyone (a good number of times, probably even by the very people who created them), but they were working well for a number of years, and made many people rich, although very likely only those that were selling them for a commission. Ultimately, the whole scheme blew up in everyone’s faces and brought us to the point where we are today.
Back to my main point, the ultimate disagreement here is about risk aversity, not whether active investing is superior to passive investing or not. So why don’t you guys just go back to investing *your own money* for your own reasons, instead of telling everybody else what to do with *their* money?
loading....
Chris, while I think you’re totally right I’m not sure your analysis of this conversation being risk averse against risk tolerant is really accurate.
It’s true that managers of funds should theoretically doing what an individual investor would do but on a larger scale. The problem is that the numbers, when you take in to account fees, just don’t add up statistically.
But I think that’s a separate discussion than whether someone is willing to invest in stocks at all. I for one see no discrepancy with avoiding actively managed funds yet researching individual stock holdings for oneself.
loading....
Two years later, the only thing FAIRX seems to be crushing is its shareholders.
loading....