Index Funds: Why Choose Anything Else?
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?
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There are 126 comments to "Index Funds: Why Choose Anything Else?".
I find it ironic that after having read a bookshelf full of investment books and spending hours upon hours looking for the perfect investment, I choose a target retirement fund composed of index funds.
Sometimes the simplest answer is the best.
I have all of my investments in index funds, including the ones Mike mentions (thanks Mike!). For those who have the time, inclination, and education to research and track individual stocks, more power to them. They can do very well. I don’t trust myself, or anyone else for that matter, to consistently beat the market, so index funds were the answer for me. With their low fees and high returns, it seems like a no-brainer.
What about for Canadians? From what I’ve been able to learn so far, there aren’t really a lot of options in this regard.
Lesley: You may want to look into exchange traded funds (ETFs). They’re essentially index funds that trade like regular stocks and can usually be purchased from any broker.
Mike from Four Pillars (a Canadian personal finance blog) has covered the topic pretty well in these two posts:
http://www.four-pillars.ca/2008/02/12/index-funds-vs-etfs/
http://www.four-pillars.ca/2008/03/28/strategies-for-etfs-and-index-funds/
I think index funds are great.
I also think that for the extra cost a fund like one of State Farm’s Lifepath funds, really a barclays global lifepath fund sold in a size that the average investor can buy, is the real answer.
No investor emotion is involved when choosing to move funds towards lower risk as time goes on, no choosing when to move funds, no decisions on rebalancing.
Really a good target date fund would work best for about 95% of America.
Unless you have Time, Inclination and Education to be an expert!!!
Ric
Thanks for the mention Mike.
Lesley – you should check out iShares.ca for etfs in Canada. Alternatively you can look at Vanguard etfs – both the iShares and Vanguard etfs along with others can be purchased in a normal discount brokerage account in Canada.
If it’s low cost index funds you want (which are a bit easier) then look into TD efunds which you buy from TD.
Because index funds are not actively managed you are exposed to ALL the price fluctuations of the broader market. The benefits of buying low and selling high are lost on these funds because there is no one there to do it. I also don’t have time to research individual stocks or the knowledge to even know what to look for. Which is precisely the reason I pay a fund manager to do it. He has a record of crushing the S&P index and continues to do it for a modest 1% fee which I’m happy to pay.
With index funds you get what you pay for – which turns out to be not very
much at all.
I hope my comment didn’t come off too negative. I think index funds have a place, but in using them you have to take the good with the bad. My point is that a fund manager has a very real ability to filter out the bad and look for the good. While at the same time taking advantage of market price fluctuations.
I don’t think your comment came off as too negative, but it certainly caught me by surprise.
I’ve NEVER heard of a manager who has CONSISTENTLY beaten the S&P index — so perhaps you’re fund manager is the first to do so.
Either way, post the fund and let’s all have a look.
Could you explain the tax implications? You touched on them briefly in this article. I haven’t done any investing outside of my 401k, and to be quite honest I have no idea how taxes work for something like this. Given your strategy of investing in index funds, and assuming this is not retirement investing (like a tax sheltered 401k), what are your tax liabilities at the end of the year?
FAIRX — The fairholme fund. Bruce Berkowitz is the manager.
http://www.fairholmefunds.com/
I agree with the other commenter that I would like to see a discussion about funds vs. ETFs.
I find the load/no-load, maintenance reqs, etc. of funds difficult to deal with and find ETFs much easier to understand.
@Russ, is that the one Jim Cramer used to manage? How has it done since he left?
From 12/29/99 when the fund was opened Through 12/04/09 FAIRX has returned 237.61% while the S&P 500 index is NEGATIVE 9.96%. Neither calculation takes re-invested dividends into account.
Russ is correct but only a small group of managers can beat the index, and an even smaller group can do it regularly
@Suzanne, NO it is not the fund Jim Cramer used to manage. Also, I didn’t intend to push a specific fund, but Matt asked for an example.
Can somebody clear this up for me?
The fund that Russ posted has a 1% expense ratio.
For the sake of argument, the Vanguard 500 index fund has a 0.18% expense ratio.
So for Russ’s fund (FAIRX) to outperform the Vanguard 500 index fund, the fund manager must deliver approx. FIVE times better results than the index fund.
Is that correct? (I’m certainly no math genius so if this is all wrong let me know.)
Matt, the fund manager has to outperform the index by 0.82% to make up the extra expense.
Using ratios isn’t really correct in this example.
Yes. 100% index or ETF. Just added a foreign index this year for the first time for more diversification. Actually, the 529 is in mutual funds because there’s a limited choice set there.
I always find it funny when I’m logging into etrade and it suggests I read what the motley fool recommends for individual stock picks. The motley fool is who originally convinced me to just stick with index funds. But I guess boring strategies are harder to keep selling unless you’re Dave Ramsey, even if they work.
EvilDave: Unless you’re planning on doing things like buying on margin or buying/selling options (both of which you can do with ETFs but not with regular index funds), the primary difference between ETFs and index funds is costs.
The two articles linked to above from Four Pillars do a good job of explaining it, or you can take a look at this article I wrote a while back.
Luke: Regarding the tax implications of index funds (as compared to other mutual funds) in a taxable account, this article may be of use: http://www.obliviousinvestor.com/tax-efficiency-of-index-funds-and-etfs/
If you have specific questions beyond that, let me know, and I’ll do my best to answer them.
No, I don’t invest in index funds. I hand-select dividend stocks and do the research. I understand a lot of people don’t think they have the time or knowledge to do this, but it only takes me a few hours a month — less than I’d spend watching one 1-hour TV show every week. And I get to invest in companies I understand.
Beating the average return is not my goal; my goal is to invest in companies with sold track records of growth. That said, I’ve handily beat the S&P 500 since I realigned my portfolio to individual stocks.
-Erica
Yes, I use a targeted index fund for all my retirement contributions. My future is in Fidelity’s hands and the folks who manage that particular fund. I’m nearing 30 so I have 30 – 35 years until retirement (I think/hope).
I also have never invested in index funds, but then for the past 20 years I’ve had a very high risk tolerance. Not so much going forward … I still have a 20+ year retirement horizon, but:
My hand-picked stocks have recovered 100% from their 11/08 low point. I think the markets are going down again soon, so I plan to sell out *very* soon while my stocks are high, then roll over the cash in my two accounts (a 401(k) from a previous employer, and a rollover IRA from a 401(k) from another employer) to the 401(k) at my new employer … where I will be parking everything in index funds because I just can’t be bothered anymore. What a pathetic admission!
@Erica, I think that is great.
I think the idea that no-one is capable of determining which companies are more likely to do well and which companies are likely to fail is hogwash.
A fund manager’s job is to do the research, look at earnings statements, balance sheets, growth prospects, scope out the competition. As an investor you are an owner — owners should know exactly what they are buying. Then after they’ve done the research the second part of their job is to get the best price.
I think it is a bit unrealistic to expect most people to do this on their own. For example the fund I mentioned earlier (FAIRX) steered clear of banks before the subprime crisis. They did this because they did the research and determined that they had no idea what was on the bank’s balance sheets. Since they couldn’t understand it, they didn’t buy it. I simply couldn’t have had this foresight myself, or the time to weed through the documents on my own. This is why I pay my fund manager. I consider it money well spent. While the index funds are negative over the last decade, my fund is up by over 230%.
That said fund managers are not created equal. Read your prospectus, if you can’t understand your fund manager’s philosophy then it’s probably not worth buying into.
Russ: What is your method for determining (ahead of time, of course) which fund managers are likely to outperform the market?
Track record and investment philosophy. I didn’t buy into FAIRX at the beginning. Or more specifically, a track record of sticking to their investment philosophy. I don’t think this concept is very radical, or even terribly difficult. Look at what philosophy the most successful investors of our time have. You don’t see Warren Buffet buying index funds (though he does recommend them for others, ironically). If someone like that can consistently find companies that do well and get them at good prices, and if I can pay them to do it for me, well thats a win-win situation.
@Ric (#5):
You could just go with a Vanguard Target Date fund and you won’t have to pay any additional fees at all. It’s actually quite ridiculous that State Farm or Barclays charge extra for their “glide path” funds. It doesn’t take that much extra work, and you can just go to Vanguard to get the same thing for no extra charge.
There is an army of financial planners that are paid commissions to get you into actively managed mutual funds. They get little money for low fee index funds so they don’t sell them. Instead they encourage their clients to chase higher returns.
In Canada, TD e-Series funds are an excellent choice.
http://www.tdcanadatrust.com/mutualfunds/tdeseriesfunds/index.jsp
Russ-
I look forward to your answer to Mike Piper’s question. You’ve done pretty well to date with that investment. It’s possible you’ve gotten lucky and hit on one of the small minority of actively managed funds that do well; it’s much more likely that your future holds a painful lesson in regression to the mean.
In addition, I hope you understand that FAIRX is not a domestic, large-cap fund, so comparing its performance with the S&P 500 index is specious.
You should also know that your statement that “index funds are negative over the last decade” is wrong. You’re considering just one index fund (S&P 500), while the original post concerned a diversified portfolio of index funds. I could just as easily look at, for example, the Vanguard Emerging Markets Index Fund, which “crushed” FAIRX over the last decade, even without accounting for expenses. Just like lottery tickets, risky, non-diversified strategies do pay off for some people, but they are not well-advised.
You made a terrific point about being able to create a well diversified portfolio using index funds. All too often when people hear “index fund” they think of a fund that simply mimics the entire stock market. There are many, many ways for us to cater our portfolio to our risk preferences using the slew of index funds now available. Great post!
I agree that index funds are better investments than mutual funds. However, I still feel they are less cost effective than simply owning a pool of stocks yourself. This will of course depend on the size of your portfolio.
I am a fan of buying the strongest lot of an index funds holdings and sitting on them. Take a look at the relative strength of each. These stocks tend to decline less than the average during a downturn and perform better durning a bull run.
We will all be able to find actively managed funds that overperformed index funds — if we look back after the fact. Since index funds reflect the market average, many managed funds will do better, and many managed funds will do worse. Index funds are a way of mitigating the risk that the managed funds or stocks you pick may be on the “worse” side of that divide. You go for the average instead of betting on your ability to identify ahead of time which funds or stocks are going to outperform the average. As I say, it’s easy to identify the superior-performing ones after the fact. It’s identifying them *before* the fact that’s the trick. Of course there will be funds that do better than average. That’s what an average is about.
Like Erica I think there is a roll of stocks in one’s portfolio. Yo do have some advantages in stocks that a mutual fund manager does not. Though, IMHO specific stocks should be a small less than 15% of your entire portfolio. Also it should be stated not everyone cares to read or will understand a financial statement, so they might be better off investing in index mutual funds or ETFs.
For me I put my stocks outside of my retirement funds. I use indexing for all retirement. Partly because there is not choice (a good portion is in 401ks), but also the above mentioned reasons in the article. What this post does not mention is asset allocation, something I know the blogger mentions on his own web site, but not on this specific post. Proper asset allocation has a big influence in your returns. William Bernstein’s books are a GREAT read on the subject.
This is great. For the truly clueless among us: how can I get started investing in an index fund? I’m self-employed, so it’s not like I can call HR and make it happen.
Greg-
OK, fair enough I did not mean to imply that FAIRX has outperformed all index funds. And my statement that index funds are negative certainly does not apply to all index funds, I was talking about the S&P 500. I apologize for being misleading. The S&P 500 is a very common benchmark, pick another and we can go from there. My point of comparison was to show that in the face of a market correction, a manager can add value. I’m sure we can find other investments that have done much better than FAIRX, and I certainly did not mean to suggest that FAIRX is the best possible investment. I only brought it up as an example of a managed fund that has done well.
I certainly understand that FAIRX is not restricted to any one sector, market, or asset class. This is part of what makes it advantageous. They actually hold 15-20% of assets in cash or very liquid securities for the purpose of taking advantage of favorable market conditions (such as the recent downturn). They are not required to be fully invested as many other funds are. They are a very focused fund investing in only 20-25 stocks at a given time. It’s intentional, why spend money on your 26th (or 50th, or 100th) best idea? They are reactionary — they do not try and guess what the future will hold, they react to what has already happened. This is their philosophy. It also happens to be the philosophy of the best investors of our time. That is why I chose it. I didn’t draw it out of a hat. FAIRX is not a lottery ticket, I reject that suggestion.
Still, You are right, I *could* have gotten lucky here. I *may* be in for a rude awakening, that is a very real possibility. But this gets to the heart of it. Do I say to myself something like “This is all much to complicated for me or anyone else to understand so I’ll just buy a little of everything and ride out whatever comes my way”? On some levels I think this is a pretty good attitude (being consistent, diversification in the face of risk, not chasing the next hot thing), but I don’t buy into the idea that we can’t determine a good investment from a bad one.
I think Russ has identified my concern with index funds. Since I am very young, and over the course of the next 30 or so years, I don’t want to miss out on the opportunity of greater returns.
With that said, I am more likely to choose index funds because of their simplicity.
Hi all – I’m Canadian, just in the process of learning to be an independent investor and I’m using the free practice demo at Questrade, and other Canadian online brokerage sites. I’m interested in dividend and index funds. I notice that I can’t “buy” any of the Vanguard 500 Index fund. In fact I get told the VFINX symbol is “invalid”. Same with Manulife Financial (MFC-T). Please don’t laugh me out of the park, but can anyone tell me what the problem is? Is it because they’re US funds? Thanks.
So, right now, I’m in Vanguard, Total Stock Index Fund, Total International Index Fund, and Total Bond Fund, in proportions appropriate for me.
Should I be further diversifying into Small CapIndex Funds, Large Cap Index Funds, and goodness knows which other Index Fund categories? Or will I be “OK” with the three I’ve picked? 🙂
@Kim – Canadians can’t buy American mutual funds. And in the spirit of free trade, they can’t buy ours either. 🙂
Foreign ETFs on the other hand can be purchased in either country. You can buy Vanguard ETFs- that’s what I have in addition to some iShares etfs.
The symbol for Manulife is MFC.to (I don’t think the caps matter). It should be there.
Sierra Black: If you’re self-employed, you can set up your own retirement plan. This article explains your different choices:
http://www.simplesubjects.com/tax/business-retirement-plans-sep-vs-simple-vs-keogh.html
For most people, either a SEP IRA or a Solo 401(k) is the best choice. Vanguard (my index fund provider of choice) offers both at a very low cost.
Julie: You already have an extremely well diversified, low-cost portfolio. That’s pretty good in my book.
That said, others would argue that you can gain additional diversification by picking up some small-cap funds and/or value funds. If you’re interested in adding funds to what you already have here are my general suggestions for the priority in which to pick them up.
I own a bit of everything. I have two ETFs, a couple index funds (Canadian), but usually I hand-pick good dividend stocks and do my own research. I like using ETFs to cover broad market areas that I don’t know as well or that are subject to more volatility, like commodities.
I also prefer hand-picking my stocks because I like to assert control over where I’m putting my money, and you don’t get that with broad-based index funds/ETFs – you will also be investing in weapons companies, alcohol, fast food and tobacco. If you’re fine with that, that’s your decision – but you might still want to know exactly what composes the index you’re investing in.
“Slow, sure path to wealth.”
Nonsense. It’s slow all right, but where does ‘sure’ come into the picture? Where’s the guarantee? It’s propaganda.
When you say that index funds ‘work’ you mean that you can anticipate performing on a par with the major market average that your fund mimics. Why is that good?
I agree that indexing seems ‘good’ because it is far, far better than using actively managed mutual funds. Those are for the ignorant investor. Those are for clients of financial advisors. But just because it’s better than mutual funds, that does not make it good. It does not make it the most intelligent choice.
But it is easy. It does let you sleep at night. It is sticking your head in the sand.
When a portion of your funds are in the stock market, you are subject to occasional huge losses. Why suffer through that? Why must you then hope for big or consistent rallies to recover those losses?
Just avoid those losses in the first place.
It’s far better to insure the portion of your assets that are invested in stocks. But the passive investors scream in horror? “What? You can do better than indexing? I refuse to believe it.”
You can do better. You can own a less volatile portfolio with smaller fluctuations in value. And with that comes the peace of mind of a GUARANTEE that loses are limited to a level – pre-determined by you.
It’s all available when adopting conservative strategies using stock options.
Mike Piper and I have discussed this before and have agreed to disagree.
Index funds are a great tool… however, investors can create their own “index” choosing the strongest stocks and leaving the laggards behind. Beat, not meet, the index.
Passively managed index funds provide an excellent foundation to diversify your portfolio.
ETFs have really come into their own and can provide additional cost effective options for more segmentation.
However, the key is not simply a buy & hold strategy, but one the involves re-balancing back to a target portfolio on a regular basis.
Keep in mind for every managed fund that has outperformed an index you could have easily picked out several that underperformed it.
Has the fund outperformed in the past? How long will it continue to outperform? Will you have to change to a different fund? It underperformed for the first time should I jump ship?
I don’t think the market is fully efficient, a good fund manager can outperform an index fund. But when you are looking at a timeline of investing for decades and decades you can bet they can’t outperform every time. One bad year can wipe out years of performance.
Diversify your funds between indexed and managed. Pick a managed fund that meets your objectives but be critical about the expense ratios and risks involved. I personally enjoy using a combination of low cost Vanguard funds (most indexed and a few managed) and buying individual stocks in my Roth IRA brokerage account.
Index funds are a great way for a passive investor to eliminate the risk involved in investing and only leave themselves the systematic risk.
They can also be a great way to diversify a portfolio for less risk. Active investors (ones that read annual reports, pay attention to company news, etc.) may not be as inclined to invest as much into index funds as the passive investor but they surely have their place.
I started investing a little over a year ago and have decided to focus on index funds in my portfolio. My question though is what indexes? I’m Canadian and our mutual funds tend to have higher MER’s, even index funds. So I decided to go with ETFs because of the lower fees. But holy smokes, it seems like they have an index for everything these days!! I even read that some company has come up with “faith-targeted ETFs”.
I just finished The New Coffeehouse Investor and Bill Schultheis talks about some of this, but I’d like to hear how other people approach this. I’d like to take advantage of gains in other sectors, so should I include things like commodity or emerging market ETFs, or should I stick to the simple peanut butter and jam: one bond fund and one domestic equity fund.
I think this would be a good issue for a future post. I’ve read a lot about why you should invest in index funds (on this site and others), but for those of us who have already been converted, it would be good to read more that takes you through the next steps–deciding on what index funds and ETFs to choose for your portfolio.
One of the major advantages of mutual funds is that you can invest comparatively small amounts per month.
I don’t know how it works in the US but here in Finland it’s not very cost effective to buy stocks or ETF’s with small amounts. You need to invest at least 600-1000 in one go to keep the costs down. Most people don’t have that kind of money to spare regularly. Most index funds here aren’t better, as they require a “startup capital” of up to 10,000€, which rules them out for most people.
If you want to invest maybe 50-100€ per month your options are VERY limited. Actively managed funds are just a LOT more accessible for the average Joe.
I think index funds are wonderful. I am personally inclined to limit myself to index funds (I don’t today have the time available to pick stocks effectively) But I don’t at all agree that investors should permanently limit themselves to index funds.
One big problem with indexing is that it makes stock investing too artificial an enterprise. Indexers have a strong inclination to dogmatism (trust me!). I believe this problem is rooted in the reality that you don’t need to understand what it is you are investing in when you invest in an index. To pick a stock, you are more or less forced to do some study first. Indexing is so simple that you can skip that step and get in way over your head. Indexing has its dangerous side (all simple approaches do).
My view is that all investors should start with indexes and stay with them if they don’t have the time nor inclination needed to do effective research. But over time those with an interest in learning enough about individual companies to buy particular stocks should do that with gradually larger portions of their portfolios. My strong hunch is that the learning process that follows will help them not only with their individual stocks but with their index fund investments as well.
Rob
I actually started out with an Index fund and a mutual fund of my choice when I started investing 3 years ago. I wanted to test if a mutual fund or market index was actually better for me. I am still down 20% on my S&P 500 index fund while I am up 20% on the mutual fund. This goes to show that picking a good fund with a history of beating the index might be worthwhile for a savvy investor.
Two questions for Mike (#51):
1. Just to check: Is the mutual fund a domestic large-cap stock fund? (If not, then the S&P 500 isn’t a very meaningful comparison.)
2. How can you tell whether the your fortunate mutual fund selection was due to a prudent choice rather than simple luck?
Or to put it differently, how can you tell that the fund manager is highly skilled (and likely to continue to beat the market) rather than simply lucky (and therefore likely to have his luck run out at any time)?
Meghan (#48): This post has a collection of low-cost, diversified “lazy portfolios” constructed with ETFs.
That said, given that you’re Canadian, it may well make sense to substitute a Canadian bond ETF for a portion (perhaps a large portion) of the bond ETFs suggested in those portfolios in order to minimize currency risk.
The fund is an international fund. If I compared it to its comparable index, the fund still beat its index by 8% since its inception. Much like the manager of FIARX, my fund manager has a history of beating the S&P 500. I don’t think it’s luck if you beat the index 9 out of the past 10 years. I’m not saying a mutual fund is for everybody. If you enjoyed your returns with your index fund, you should stick with it. I have been disappointed with my index experience so I intend to reward my mutual fund by placing the majority of my retirement income with them.
Mike: At any given time, due purely to chance, there should be approximately 32 equity funds that have outperformed the market in 9 of the last 10 years.
I’m not saying that your fund’s performance is due to luck. I’m just trying to point out that it’s quite difficult to know for sure one way or the other.
I’d urge you to be very careful about “placing the majority of your retirement income” with any given fund manager.
I am also impressed with the leadership and performance of the FAIRX fund. I may decide to invest with them as well. Using Fidelity’s investor tools you can see how handily it beat the S&P 500 index.
http://personal.fidelity.com/products/funds/mfl_frame.shtml?315912204&rsrch=gqb
Simply type FAIRX on the compare funds bar and click 10 years for time frame. It shows that that you would’ve made $20000 more for your $10000 investment than you would’ve with the S&P 500 index.
Don’t worry, I’m only using my Roth for mutual funds. My 401k at work forces me to use index funds. I still have a substantial amount in there. Hopefully my returns at my 401k will in time match my mutual fund’s performance, unfortunately I doubt that it will.
Great post! When I began with my company about 2 and a half years ago, I was automatically enrolled in a 401k and it was put into some sort of Fidelity thing which was supposed to change with the years as I near retirement. I’m not even 30 yet so it was the “youngest” option they had.
I think it was just over a year ago or so, I started doing my research on retirement and decided to change from the Fidelity thing to my own decisions. I diversified as simply as I could which was in a Large-Cap (Vanguard Institutional Index), International (AF Europac Growth), and a tiny portion in Pimco Total Return.
I’m pretty happy with my portfolio, although I know close to nothing about investing. I do think that one day, I might very well become a bit more active of an investor because I find it fascinating.
@Meghan (48) I use iShares XSB (short term bond ETF) for my “bond” allocation.
iShares XIU is good for Canadian equity. It’s the TSX top 60 and has an mer of only 0.17%.
Foreign ETFs I use Vanguard VTI (US equities) and VEA (europe and asia). If you don’t want to covert to US$ then just buy the iShares equivalents. Go to iShares.ca to find out more.
I’ve read that there is an inherent problem if a significant portion of investors choose to buy index funds. I don’t remember the details; it’s something like if in 30 years everyone starts retiring and selling stocks in the S&P 500, then prices will shoot down. Sorry I don’t have a better understanding of the concerns, but can you speak to that at all?
It also strikes me that we are beginning to think of index funds as a “guaranteed” return. We are treating them like high-interest savings accounts, when the stock market was never meant to be treated in such a fashion. It makes me worry that we’re all headed for a serious reality check.
Can anyone explain, or refer me to somewhere that explains the similarities and differences btwn index funds and the target date funds. They are both appealing to me as passive investments with low/no fees. I get that index funds buy some of all stocks in the market, and target dates don’t necessarily do that. and that target date funds change as you get closer to retirement to be more conservative. I guess my point is this: i have all of my retirement funds in target date accounts (fidelity and tiaa-cref) – and those are my only investments, should i spread some of that out into index funds as well?
Wow. There is so much propaganda and false information in these comments, it’s making my head spin.
If you don’t read the rest of this post, then at least read this: Before you commit your life savings to a particular strategy – whether it’s the index funds recommended by Mike, or the actively managed funds advocated by Russ, or the individual stock picking pushed by Mark, read “The Little Book of Common Sense Investing,” by John Bogle. Bogle was the man who created Vanguard, the enormously successful investment brokerage in the US. I think he knows a little bit more about the markets than a couple random, anonymous blog commenters. PLEASE read this book before you blindly follow any strategy described in these comments.
With that out of the way, I have a few comments.
To Lesley: Check out TD Waterhouse. They have a wide variety of low-fee index funds, particularly their e-Series of funds. I’m invested in the TSX, the Dow, and the S&P500 index funds in my TD Waterhouse RRSP and TFSA accounts. Of course, you can also buy individual stocks and ETFs through them.
Now, I could spend the rest of the day ripping apart Russ and Mark’s misinformation, but the bulk of the legwork has already been done by John Bogle (mentioned above), William Bernstein (“The Four Pillars of Investing”), Andrew Tobias (“The Only Investment Guide You’ll Ever Need”), Burton Malkiel (“A Random Walk Down Wall Street”), and many, many other actual EXPERTS who have done the actual research, studied literally CENTURIES of data extensively, and all reached the conclusion that an index-based strategy will, on average, outperform an actively managed strategy.
The simple fact of the matter is that there’s only one market. Indexers, fund managers, individual investors, pension fund managers, hedge fund managers, and everybody else are all just trading with each other. They can’t ALL be “above average.” But, they all do expect to be paid. The catch is that they’re not all playing on a level playing field.
Pension and hedge fund managers have unique advantages and constraints, owing to the enormous sums of money they’re able to move around. They have access to instantaneous information. Their full-time job is to stay on top of the markets, and react immediately to any changes. By having such huge piles of cash to move around with little restrictions, they are actually able to affect the price of the stocks they’re trading. Keep in mind that the stock ticker prices you see are simply the price at which that stock was last traded. So just because some Joe somewhere was willing to buy 30 shares of IBM for $130 ea. doesn’t mean that the California Teachers’ Pension Fund can then go ahead and unload 75,000 shares at the same price. It’s extremely unlikely that there will be enough buyers willing to absorb that many shares at that price. Consequently, as they begin selling those 75,000 shares, the price will drop, as fewer and fewer investors willing to pay that price can be found.
Active mutual fund managers often have similarly large amounts of money to shift, but they are more limited by fund mandates, federal regulations, and other factors that make it difficult for them to make the rapid, big moves that hedge fund and pension fund managers can make. However, they do still have the luxury of studying the markets full-time, with access to literally instantaneous information.
The bottom line is, you cannot compete with these people on the basis of information. You will never be able to consistently take advantage of a market inefficiency due to a piece of information you have that they do not (well, not legally anyway). It is pointless to even try. They will win, because they simply have better systems, more experience, and faster access to information and trades.
Now, regarding actively managed funds.
Russ: “The benefits of buying low and selling high are lost on [index] funds because there is no one there to do it.”
It is impossible to consistently “buy low and sell high” in the short term. This has been proven repeatedly, by the numerous industry luminaries I cited above. The problem is, at any given price point, it is impossible to know whether that price represents a “high” or a “low.” It may look high, but how can you be sure it won’t be even higher tomorrow? It may look low, but it can always go lower, or even bankrupt. Many companies have done exactly that.
Russ: “My point is that a fund manager has a very real ability to filter out the bad and look for the good”
No, he does not. This is simply false. No fund manager in the history of ever has demonstrated a consistent ability to pick winners. Peter Lynch came the closest. History backs me up. Do your homework (or just read the books I listed above – they’ve already done the research for you).
Erica: “Beating the average return is not my goal; my goal is to invest in companies with sold track records of growth.”
As Bernstein demonstrated in “The Four Pillars of Investing,” the biggest gains come from the companies that look like the worst dogs. The problem with companies with “solid track records of growth” is that they’re fairly valued. Everybody knows that they’re safe bets, so they’re valued quite highly. There’s no room to find “bargains” there. You’ll get a relatively safe, low-risk return, which means a low return. On the other hand, the companies that few people want to touch, but are able to succeed anyway, offer the best returns. They’re higher risk, but consequently generate higher returns. This is all very clearly and elequently explained in Bernstein’s book.
chacha1: “I think the markets are going down again soon”
And what makes you think your guess is any more likely than the guesses of the millions of people whose buying and selling actually defines which way the market goes? What makes you think you know better than the pension and hedge fund managers at the helm of literally TRILLIONS of dollars in the market? If they believed as you do, that “the markets are going down again soon,” why wouldn’t they sell their stocks and move to a cash position? Of course, given the enormous amount of capital that represents, such an action would itself precipitate a huge drop in the markets, producing a self-fulfilling prophecy. The simple and obvious fact that the markets HAVEN’T gone down again yet is proof that those fund managers are confident that the markets will in fact continue to rise over the long term. And if someone with decades of experience and education, with access to instantaneous information, responsible for hundreds of billions of dollars, and the pensions of tens of thousands of people is willing to bet that the markets will continue to rise, why wouldn’t you believe them, rather than your own gut feeling? Isn’t that a little arrogant?
Russ: “You don’t see Warren Buffet buying index funds”
Warren Buffet doesn’t pick and choose stocks, either, Russ. He buys entire companies, tweaks them, then reaps the profits directly, not through increased share price. And as you noted, he does in fact advocate index funds for the individual investor.
Russ has made a big deal out of highlighting one or two funds that have outperformed a few specific indexes. Let me be clear: I’m not saying that no mutual fund can beat a given market average. Of course such funds exist. The problem is that it is impossible to know in advance whether a given fund will outperform a corresponding index. Russ is glossing over a concept called “survivorship bias.” That is, mutual fund companies kill off underperforming funds. Not just because it makes them look bad, but because a large number of people actually believe as Russ does – that past performance is an indicator of future gains. Thus, when they see a fund that has lost money for the past 5 years, they decline to invest in it. Investors who were already in it pull their money out. So the mutual fund company kills it off, and rolls whatever remaining investors were still in it into another fund. In doing so, it creates the illusion that the mutual fund company has a stable of funds that all outperform the average. Of course, only a tiny percentage of those funds are more than a decade old, and they don’t tell you that back when those “winners” were first created, they had dozens of peers who all underperformed and were eventually killed off. But that’s the truth.
Mark Wolfinger makes some vague references to “avoiding those losses” and “insuring the portion of your assets that are invested in stocks.” He’s talking about call and put options, and he has several books to sell you on those topics. So consider that before you take his advice at face value. He has an agenda, and when he misrepresents his advice as simple, well-meaning help, he’s putting himself in a conflict of interest. Make no mistake – his first interest is his own, in the form of selling books to you. Click his name and see for yourself.
Doctor Stock: “Investors can create their own ‘index’ choosing the strongest stocks and leaving the laggards behind. Beat, not meet, the index.”
This is the same fallacy I already addressed with Erica. The biggest “losers” are the ones that produce the biggest returns. This is called “value investing.” It’s covered extensively in Bernstein’s “Four Pillars.” Though I can understand why “Doctor Stock” would be motivated to stir the pot on this topic. He’s been blogging for a whole month now, trying to generate hits and profit on this topic.
Follow the money, folks. Be suspicious of people – they almost always have an ulterior motive, from the nice financial advisor who thinks you should invest in a particular fund, to the friendly blog commenter who wants to sell you his book or get you to sign up for his own blog. I don’t have a finance blog. My name is not a link. I just want you to be informed, and not get taken advantage of by these snakes, like I did. Read Bernstein’s “Four Pillars” or Bogle’s “Little Book of Common Sense Investing,” it’ll open your eyes. I don’t make any money from them, I didn’t write them, and I’m not even using an affiliate link. I don’t want your money. 🙂 I just want you to not make a huge mistake by falling for the snake oil these “actively managed” stock-picking advocates are selling.
Imelda: I’d say we got that reality check in 2008-2009!
There’s no guarantee that stocks will go up over any given period. I’d definitely suggest that most investors hold a variety of asset classes (i.e., more than just stocks) unless they’re comfortable with extreme volatility.
The “guarantee” of index funds is simply that they’ll outperform the majority of dollars invested in actively managed funds (due to the difference in costs).
As to what would happen to stock prices if demand for stocks declined (due to retirees selling their portfolios): Yes, that’s possible. Remember though that actively managed stock mutual funds would be hit in just the same way.
The trick, again, is to keep a diversified portfolio.
Arguing index vs. non-index investing is like arguing politics – you’ll never convince the other side you’re right. EDIT: Because there is no “right”.
One answer to the blog’s question is my big issue with index funds: They are guaranteed to hang on to losers too long. Witness that GM was not dropped from the S&P 500 until June 2009 even though everyone and their brother could tell you they were in big trouble well before that.
Another answer: the current dividend yield is about 2%. For me, that is way too dependent on future price appreciation as part of overall return on the investment. I prefer to find stocks that yield around 5% or so and get current income I can reinvest along with potential price appreciation.
That being said, do what works for you personally and lets you sleep at night.
@Mike (#54) – Comparing an international fund to the S&P500 is comparing apples to oranges. Don’t forget with the American dollar dropping as much as it has this year, most foreign funds get a huge boost from that fact alone even if they do a poor job stock picking.
I have to say that on this thread there are too many commenters named “Mike” (including myself) and way too many Canucks! 🙂
It makes me worry that we’re all headed for a serious reality check.
Your concerns are well-founded, Imelda. I strongly disagree with Mike’s suggestion that we have already seen the reality check that we are going to experience for having fallen for the Buy-and-Hold gibberish one more time.
The first three times that large numbers of people fell for this most dangerous of all investing “strategies,” we ended up at valuation levels of one-half fair value. That would be a drop in prices of roughly 70 percent from where we are today.
It is right to say that we have begun paying the price for teaching middle-class investors to ignore the prices at which they buy stocks. But we are still in the early days of this secular bear market. If you go by what has always happened in the past when large numbers of people came to believe that Buy-and-Hold investing might work in the real world, we will be lucky if we don’t end up living through The Second Great Depression in days to come.
I very much hope it doesn’t come to that. But I wouldn’t want to bet a whole big bunch of money on the possibility that it won’t.
Rob
I’d be interested in what knowledgeable folks think of using an index fund, such as Vanguard 500, for an IRA. I’ve had my TSA-cum-IRA in FGRIX for a couple of decades and finally have decided I should maybe do something different. I’ve been withdrawing my RMDs for some six years now.
@Kevin (the long post)
I will take your criticisms into consideration and look into the literature you suggested.
I’m not so sure we disagree as much as you think. Warren Buffet does not actively manage the companies he buys, he often keeps existing management in place. I think that if you buy stocks the way he buys companies it can add value over buying a little of everything. I’d rather do what warren buffet does, and not what he says. I don’t have the expertise to do as well on my own, so it is very reasonable for me to consider paying someone else to do this for me (a fund manager). If I couldn’t find a fund that lives up to this philosophy, then I would have to come up with another plan, maybe even index funds.
I don’t need for all managed funds to do better than index funds, I only need one managed fund to not lose me money and provide value added over and above the management fee.
My bottom line is that it is possible to tell a good investment from a bad one. Warren Buffet does it over and over, why do you accept his philosophy but say it would be bad to pay someone else to do the same thing for you?
Lastly, good ideas are hard to find I think, so as a fund’s size increases it is reasonable to expect the value added to be diminished. Warren Buffet admits this, he warns his investors that he doesn’t expect to beat the S&P 500 index by more than a few points — there just aren’t enough stellar companies to buy.
Oreo:
Target date funds are simply funds that own other mutual funds (and that adjust the allocation between those funds over time).
A target date fund may own index funds (as in the case of Vanguard’s target funds), or it may own actively managed mutual funds (as in the case of Fidelity’s target date funds).
I really like Vanguard’s target date funds (assuming you can find one that fits your desired asset allocation) because they’re very low cost, but I don’t like those run by many other companies. By way of comparison:
Vanguard’s Target 2025 Fund has an expense ratio of 0.18% per year.
TIAA-CREF’s Lifecycle 2025 fund has an expense ratio of 0.70% per year.
Fidelity’s Freedom 2025 fund has an expense ratio of 0.74% per year.
An extra 0.5% in costs may not sound like much, but compounded over a few decades it can really add up!
If you want to stick with Fidelity, I’d suggest checking out their “Spartan” funds. They’re index funds that are often even cheaper than those offered by Vanguard.
hfrankjr:
Index funds (including Vanguard’s 500 fund) can be a great way to put together a portfolio in an IRA.
Just make sure to put together a diversified portfolio with an asset allocation that fits your needs rather than investing in just a single large-cap US stock fund.
@ Russ
Warren Buffet promotes index funds for the average investor as just about every professional manager does. There is a reason for this, and not just because its good advice for the average small time investor. To outperform the market an investor has to bet against it and succeed more than 50% of the time. The market in general promotes herd mentality. The more individuals pushing capital into an index fund the larger the herd is that is moving the market. Fund managers have to take the opposite position and bet against select companies to try and ensure they succeed the majority of the time.
We know our market is not completely efficient. There are opportunities for arbitrage, undervalued, and overvalued securities. The more individuals in an index fund the fewer individuals who are actively seeking out these opportunities to make profits. If all these individuals were actively seeking out individual stocks, while most wouldn’t even understand what to look for, inevitably some would stumble upon these opportunities and capitalize on them. Even a blind squirrel can find a nut. As these opportunities are found the market is corrected up or down until the arbitrage opportunity is no longer available. This leaves fewer opportunities for the professional managers who spend their days searching for quality businesses that are either undervalued or overvalued.
Its a win-win for professionals to promote index funds. They are providing legitimate advice for the average investors that in turn also benefits their own opportunities.
Can you make money flipping houses? Sure! Lots of people do. But for every successful flipper there are 10 n00bs that fail and decide it is too risky a proposition. Can you make money starting a business? Of course! But for every successful business there are 4 others that failed in the first year. Can you make money blogging? Yup. But for every full time blogger there are (I would wager) hundreds that make less than $100 a month for their time and effort.
This is, essentially, the difference between researching and hand-picking your own stocks vs. just plopping your money into an index fund. If you have the time and talent you can absolutely make more on your own. Would you advise someone not to start their own business because, statistically, they will probably fail? Would you advise them not to waste their time blogging because they will probably never amount to anything? Or, would you tell them the statistical reality while also giving them tips on how to be in the minority? I think the latter is a more mature and realistic approach.
One more thing directed at Kevin who said “Warren Buffet doesn’t pick and choose stocks, either, Russ. He buys entire companies, tweaks them, then reaps the profits directly, not through increased share price.”
Yes, its true that today Buffet buys large stakes in companies. This was not the case when he first started investing. He started small like the rest of us, outperformed the market over several years and then created a number of partnerships in which he began investing a group of partner’s money who agreed after seeing the progress he was making on his own. He significantly outperformed the market again over several years and eventually consolidated these partnerships into one. It was at this time that he began buying material stakes in other companies. While you mention that Buffet touts Index funds it is important to note that he has repeatedly argued that it is also possible to outperform the market over an extended period and has provided evidence by citing the returns of many disciples of Benjamin Graham. He only touts index funds for the average small time investor. Please know what you’re saying before writing instead of listing a few investment books to make a point.
James: Yes, Warren Buffett does argue that investors can potentially earn above-market returns.
He also, however, makes it explicitly clear that the overwhelming majority of people shouldn’t try. That is, he doesn’t just recommend index funds for “average small time investors.” He recommends them for “98, 99, or maybe more than 99% of investors.”
http://www.youtube.com/watch?v=P-PobeU4Ox0#t=1m29s
Well of course. As I stated above it is good advice for the average small time investor but it also benefits Buffet to promote it. Please read post #71. I’m not arguing against indexing as it has its benefits, but I’m just pointing out that it is not the only option as many blogs make it out to be.
Let me say up front that I agree with a lot of what’s in this article, and index funds are a part of my investment strategy.
However, here’s my problem with Mike’s argument, and everyone following who espouses the Index Fund-only theory. The only difference between your justifications, and those of Russ, Erica and those on the other side of the coin is frame of reference. EVERY SINGLE ONE OF US, no matter which side of the argument we fall on are looking into the PAST, and picking and choosing the time frame and statistics that prove our point.
Index funders are so quick to yell and scream that you can’t use past performance to predict future performance, yet all you do is throw me numbers from the past. Just because Index fund investing works when looking at the past doesn’t mean it will work for the person who’s ready to invest right now.
As far as time frames go, it falls back to a concept Einstein was a fan of called frames of reference. Index funders are so quick to dismiss someone like Russ espousing his fund that has beaten the S&P while he’s been invested, but how do you respond? You “crunch the numbers” and show that looking in some other time frame (the history of the market is a popular one, or as Kevin said “CENTURIES of data”), index funds outperform actively managed strategies. It’s so enticing to see the numbers that say in the history of the market, the index is your best bet, but back to frames of reference, I could care less what the best investment was over any time period ever, except for the period from the day that I invest my hard-earned money to the day I cash it out. So, unless you can see the future and know whether an index will be better over that period, Don’t tell me that you KNOW what the best investment is. And in Kevin’s case, don’t freak out and call everyone who disagrees with you propaganda pushers. Your data’s no better or worse than theirs, just different.
To take a quote from Kevin’s post, that may well be the longest blog reply in the history of GRS: “it is impossible to know in advance whether a given fund will outperform a corresponding index”. To that I respond: Yes, and it is equally impossible to know in advance whether a corresponding index will outperform a given fund. The argument goes both ways, and is therefore a moot point.
For full disclosure, I’ve read all the books Kevin mentions, and many more on investing. I’m a huge fan of Bogle, but I find that my strategy falls a little more in the middle. As many others have said there is a place for Index funds in most portfolios, and I have some in mine, but I also find value and opportunity in other forms of investment.
James, you’re comparing apples and oranges. When Warren Buffet started investing, it was a completely different environment. People still harbored a post-depression “hoarding” mentality with their money. Information was much, much slower to disseminate back when the Internet wasn’t yet even a twinkle in Al Gore’s eye. Index funds did not exist. Easy access to trading by lay persons did not exist. Transaction fees were astronomically high, compared to modern brokerage fees.
So what does all that mean? It means market inefficiencies – while rare – could still be found, if you knew where to look. Buffet dedicated his time to looking for them. Nowadays, however, those market inefficiencies simply do not happen. One of his earliest acquisitions was a map-making company valued at $45/share. However, the map-making company also had an investment portfolio worth $65/share on its own. Thus, Buffet was able to acquire the investment portfolio for $20/share less than the portfolio was objectively worth, with the map business thrown in for free! Do you think such bargains are out there today, just waiting for an armchair investor to discover? Maybe you do. But I know better.
It’s a different world. I don’t pretend I can be the next Warren Buffet. But I do own some Berkshire Hathaway stock (class B, not class A).
Will: “Index funders are so quick to yell and scream that you can’t use past performance to predict future performance, yet all you do is throw me numbers from the past.”
Will, you couldn’t be more wrong. Your point is directly addressed in Bogle’s “The Little Book of Common Sense Investing.” 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.
With actively-managed mutual funds, those fund managers skim a fee off the top of your money for the privilege of adding their “expertise.” Thus, you invest $10,000 with them, and you get $9,800 worth of stock. A year later, they trade it some more, and you’re down to $9,600 worth of stock, plus whatever swings the market has taken in the mean time. Someone who bought an index fund, however, didn’t have that 2% skimmed off the top at the beginning. So they started out with the whole $10,000 in stock, instead of $9,800. Thus, if the stock went up in value by 10%, they made more money than you, because they had an extra $200 worth of stock that the fund manager didn’t pocket and spend on fancy ties.
It has nothing to do with history. It has to do with the “dragging” effect created by the high fees inherent in actively-managed mutual funds. Worse still, those fees compound every year, with the result being a tremendous amount of wealth being siphoned off from your portfolio.
All this happens regardless of whether the market goes up or down. If the market goes up, you don’t gain as much as indexers. If the market goes down, you lose more than indexers, because those managers take their fees out no matter whether they’re right or wrong.
Kevin: “It has nothing to do with history. It has to do with the “dragging” effect created by the high fees inherent in actively-managed mutual funds.”
You’re assuming that the actively managed funds have the exact same return as the index, and therefore the fee is what makes the difference. But, they will almost never have the same return unless the active manager is just investing in the index in which case you’re being scammed. You don’t go into an actively managed fund expecting the same return as an index, that would be ridiculous.
Wow… who knew arguments were so heated.
Most people above seem to agree that index funds are better than mutual funds because of the fees managers charge (meaning managers have to beat the market by quite a bit to beat the market minus costs… yet they still only match the market on average). Whether to spend time researching and picking stocks seems to be the big disagreement.
My time is much too valuable to spend worrying about stocks. I would much rather have people who enjoy that sort of thing get the arbitrage opportunities (and take the risk) so things are priced right, and I’ll just free-ride.
Someone above said studying the market only takes a few hours a month… many of us don’t like to spend more than a few hours a year dealing with that. At least I’m in the stock market rather than keeping all our money in a checking account at .05% interest. Didn’t a brilliant man once say, “The perfect is the enemy of the good”?
Good Lord, I can’t believe people are debating this. This is just common sense. I mean think about it logically for just one second.
It’s common sense. In order for there to be “winners”, there must – by definition – be “losers.” We cannot all be above average. Surely you agree with that – it’s a mathematical tautology.
So if you accept the idea that not everyone can be above average, how is it anything other than unmitigated arrogance to believe that you are capable of picking and choosing winning stocks better than experienced professionals with instantaneous information and hundreds of billions of dollars at their disposal? You recognize that such institutional investors comprise the majority of the markets, right? And you further recognize that they are under enormous pressure to be “above average,” and dedicate their entire careers to doing so, right?
So what exactly is it you think is going to happen? Do you think small time investors like you can somehow do better than those institutional investors, so that you will consistenly find yourself on the winning side of “average” every year from now until you retire? Don’t you see then, that by definition, you’re assuming those institutional investors must mathematically fall on the losing side of “average?” Does that really seem likely to you? That those investors, doing it full time, with decades of experience, and access to enormous amounts of instantaneous information, history, financial reports, statistical models, and everything else, will underperform the market average, while you, with your 20-minute delayed quotes from Yahoo Finance, and your low-priority trade requests on eTrade, will consistently come out ahead?
Don’t you see how insanely absurd that concept is?
Don’t you see why your best hope is to simply minimize expenses and accept the average performance?
I thought we were arguing between actively managed funds and index funds. You seem to really believe that the professionals with their advantages are going to win, so why not let them invest for you? You seem to be arguing both sides.
It seems to me that throwing out a bunch of reasons why professionals have all the advantages and “armchair investors” are always going to lose makes Russ’ point that you should let a professional invest your money.
Will: “You’re assuming that the actively managed funds have the exact same return as the index”
On average, they must. Don’t you see, Will? That’s what makes it an “average.” Some will outperform, some will underperform. But they’re all playing in the same market as you and me – they don’t have their own, separate market where they can, as an aggregate, all do better than the average of the S&P 500.
It’s all the same pool of money and stocks. They are constrained by the same laws of math that you and I are. There’s only one “average” value, and their performance feeds into it, just as yours and mine do. If all (or even most) actively managed mutual funds are able to generate above-average returns, then who are the losers? Don’t you see? There has to be an equal number of losers on the other side of the “average” – otherwise it’s not an average!
Mutual funds are just as likely to be evenly-distributed around the “average” as pension fund managers, university endowment managers, or any other institutional investory with equal access to tools, research, and information. However, they do have a substantial advantage over the individual investor, because we do not have the luxury of monitoring the markets full-time, nor do we have access to the information and tools that they do. And I don’t know about you, but I certainly don’t have access to the amount of experience that they do.
But the scary thing is, even with all those advantages, statistics show that mutual fund managers are no better at consistently picking winners than a random algorithm. Some get lucky for a while, but eventually, they always make mistakes.
Kevin, I agree that the opportunities that were so grossly and blatantly undervalued or overvalued no longer exist. But, the opportunities are definitely still there especially in the small caps and given a significant margin of error there are profit opportunities everywhere. Buffet himself even stated the only thing holding him back from much higher returns currently is the sheer amount of capital he has to work with. He can’t invest in these small companies without taking an ownership stake in them. Even if he does the size of the investment is immaterial to his entire portfolio.
Will: “I thought we were arguing between actively managed funds and index funds. You seem to really believe that the professionals with their advantages are going to win, so why not let them invest for you?”
Because of the fees.
The fees make the difference.
The fees they charge are greater than the value they add. That’s why.
And where do you get those “averages”? From HISTORICAL DATA. Let me repeat, I don’t care how good or bad index funds were in the past, just like I don’t care how the “average” actively managed fund performed over the past.
You keep going back to your closed system argument…I get it. The fact that there has to be an equal number of winners and losers is meaningless to me, who cares? You seem to think that because there have to be losers, that we’re all going to be losers, so let’s shoot for average. That’s awesome if it works for you, but don’t be so close-minded. You don’t know any better than anyone else what’s going to be the best investment in the future.
You kinda shot your argument in the foot with that last line Will lol.
Will, the bottom line is, even with all their experience, education, information, and tools, mutual fund managers, over the long term, will only match the market average. Not one single manager in history has been able to demonstrate an ability to consistently beat the market average, although Peter Lynch had a great run.
Thus, if the best you can hope for over the long run is average returns, why would you let them skim a 2% management fee off your money every year, if you have an equally likely chance of outperforming or underperforming the market average anyway? Keep in mind that that performance is measured before they take their fee out. So even if they have a year where they perfectly match the average, you’re still down 2%, because of their fees.
This conclusion is based on decades of statistics and research. And yes, I know that’s looking at “history,” which you complained about. But the alternative is to believe that at some point in the future, there will eventually emerge an individual capable of consistently beating the market.
The problem is, even if such an individual does eventually emerge, and beat the market every year until he dies, that is of absolutely no use to you at all unless you have a time machine and can travel back in time and start investing with him from the beginning. That is, there is no way to identify winning managers ahead of time. You can find one who’s been “winning” for 5, 10, or 20 years, but you can never really be certain whether or not you’re jumping aboard just before he has his first “losing” year.
Furthermore, if it were in fact possible for such an individual to exist, I think it’s highly likely he would have emerged by now. With all the money at stake, and all the people who have tried, if no one has shown up by now, I don’t think they’re coming. I suppose it’s possible I’m wrong, and they might show up, but I’m not willing to bet 2% of my retirement nest egg not only on the possibility that he/she will eventually exist, but that I can successfully identify him/her.
Kevin: “The fees they charge are greater than the value they add.”
That’s a completely unprovable statement.
2 is greater than Orange
Lamp is greater than gravy
See I can do it too. It’s fun.
Let me repeat, I don’t need someone to beat the market over their lifetime, just over the time I invest with them. You can’t say with any more certainty than I can that your index fund will beat fund XYZ in the period from today to June 19th, 2015 (just made that date up), so why is your investment better than mine?
“Because of the fees.
The fees make the difference.
The fees they charge are greater than the value they add. That’s why.”
Note that this is empirically true. Terrance O’Dean wrote a couple of wonderful papers on this, as have many people since then. O’Dean also finds that women out-perform men in stocks because they don’t trade as much so don’t lose as much in transaction fees.
I was just reading https://www.getrichslowly.org/why-smart-people-make-big-money-mistakes-and-how-to-correct-them/ (the book, not the blog entry) this weekend and it goes even more into detail about how mentally we’re more likely to do exactly the wrong thing when it comes to actively managing stocks. You have to be very careful (and aware of what you’re doing) not to want to do the wrong thing.
I hear ya Nicole, but you can’t back up an argument with “empirical truths” and not expect some argument about it.
I agree with Will in that its not important whether a manager beats the index every single year or not. Whats more important is looking back and seeing whether the compounded average of your portfolio over say 10-15 years outperforms the compounded average of the index. Its nearly impossible for anyone to beat the market every single year because yearly spans in the market are more influenced by behavioral psychology and macro economic indicators than company financial results. But who cares as long as your long-term average is better.
Will: “You can’t say with any more certainty than I can that your index fund will beat fund XYZ in the period from today to June 19th, 2015 (just made that date up), so why is your investment better than mine?”
Because statistically, of all the mutual funds that have ever existed, 98-ish% of them have failed to beat their corresponding market average, after fees are accounted for.
I suppose it’s possible that I could get lucky and pick a fund that ends up being in that 2% that turn out to be “winners,” but those are pretty long odds. Furthermore, since I know you hate historical data, I guess it’s possible that those statistics could reverse in the future, and 95% of funds could end up beating the averages, as fund managers finally figure how to do their jobs 50 years after the mutual fund industry was created. But I’m not too confident in that outcome, either.
I’ve read enough books to know how badly the odds are stacked against me. I know my own limitations and risk tolerance. I’m choosing to minimize expenses and accept an average return.
It’s also enlightening to consider the mutual fund industry itself. With such an enormous amount of money at stake, it’s in their best interest to perpetuate the idea that they’re worth their fees and are adding value. They may even make some compelling arguments. But if you lift the covers and look at what they actually do, you realize that it’s just another business. They get paid regardless of their performance. Does that seem fair to you? You take all the risk, and they get paid regardless of whether or not they deliver?
No thanks.
Someone else made the point above about Warren Buffett, but it’s also true for people individually arguing…
If you have the best manager in the world, then it isn’t in your best interest to share that information. You can only beat the market if there’s arbitrage. Once everybody knows your secret, the arbitrage goes away.
Will: When you say, “You can’t say with any more certainty than I can that your index fund will beat fund XYZ in the period from today to June 19th, 2015.”
…you’re right, of course. What can be said with certainty is that a dollar invested in a low-cost index fund will beat the average actively managed dollar over every single period.
It’s what William Sharpe referred to as “The Arithmetic of Active Mangement.”
Knowing that your dollars will earn above-average returns (if we measure “average” as the average actually earned by investors) is a promise that can’t be made by picking stocks or by actively managed funds.
ERRRRR wrong again Mike.
It cannot be said with any certainty that a dollar invested in a low-cost index fund will beat an individual investor who actively manages his own portfolio of stocks over every single period. Just to shoot your point down I could invest in 1 small cap stock knowing it is undervalued and has solid earnings potential. It returns 45% over the year period, far better than the market average ever will be and you’re done.
“It cannot be said with any certainty that a dollar invested in a low-cost index fund will beat an individual investor who actively manages his own portfolio of stocks over every single period.”
I did not make that claim. What I said was that the average passively invested dollar will beat the average actively invested dollar. (Obviously this doesn’t mean that it will beat all actively invested dollars.)
Kevin: “I suppose it’s possible that I could get lucky and pick a fund that ends up being in that 2% that turn out to be winners…I guess it’s possible that those statistics could reverse in the future, and 95% of funds could end up beating the averages, as fund managers finally figure how to do their jobs 50 years after the mutual fund industry was created.”
That’s all I wanted to hear you say. I have no problem that you have an investment strategy that you think is the best. I just have a problem when you start patronizing people by calling any idea that’s different from your own “propaganda”, and saying things like: “Good Lord, I can’t believe people are debating this. This is just common sense.”
We should always debate something like this. The second we stop arguing, and start taking opinions of others as fact, that’s when I get scared. That’s why I love GRS. Some of the smartest PF debates you can find.
If you want another one that I’m SURE will get you going, check out our argument on Dollar Cost Averaging a month or 2 ago.
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.
“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.
——
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.
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.
“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
@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.
Russ good point.
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!
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.
Meow!
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.
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.
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.
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.
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.
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.
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!
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.
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
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.
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.
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?
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.
Two years later, the only thing FAIRX seems to be crushing is its shareholders.
Index funds over time will outperform actively managed funds it is a proven fact