Investing in the market seems complicated and daunting, and there’s many in the financial industry who want to keep it that way. Rather than sifting through the tens of thousands of investment options, most of us hire a professional to do it for us. These financial pros normally recommend high-growth mutual funds, and since they’re the experts, we trust them and buy the funds they recommend.
Using actively managed mutual funds and hiring professionals to invest for us sound great on the surface, but when we pull back the veil, we realize just how dark and damaging it can be to our financial future.
There’s a way to avoid these pitfalls, and I’ll show you how.
The Dark Side of Actively Managed Mutual Funds
Actively managed mutual funds take away from our financial freedom in several ways. Here are those that have the greatest impact.
Mutual Funds Are Expensive
The average cost of owning a mutual fund is 3.17% of the amount invested per year! Now if that doesn’t seem like a lot, just realize that there are superior investments that cost closer to 0.14%. In other words, mutual funds are more than 20 times, or 2,000% more expensive than the superior index funds I recommend.
For more information, see The Dirty Little Secret of Mutual Funds.
Mutual Funds Don’t Beat the Market
You’d think since mutual funds are so expensive that their returns would outpace the market, but that isn’t normally the case. 96% of mutual funds fail to beat the market over any sustained period, and on average, they return 2% per year less to shareholders. This is probably why 49% of mutual fund managers don’t even invest in the fund they manage. High fees and subpar performance are a double whammy to our financial future’s gut.
Fund Companies are Marketing Machines
The mutual fund industry is massive and totals nearly $13 trillion of our savings. But why is it so big considering that mutual funds are expensive and generate subpar performance?
The greatest marketing tool these fund companies use is probably the massive sales force they employ. Salesman, masked as financial advisers and the like, push funds that pay high commissions. Since they’re the “pros,” we trust their recommendations and act on their advice.
The strong sales force boast high average returns, which are enticing to see but very different from what the investors actually make (see arithmetic versus geometric averages on this previous post). Advertised returns are plagued with marketing manipulation that lures us into inferior investments and can blind us from our own investments’ poor performance.
The Dark Side of Hiring Professionals
There are many situations where hiring a financial professional makes complete sense. For example, we should hire them for tax planning guidance, complicated financial advice, setting up trusts, and stashing money into alternative investments outside of the typical stock and bond markets (real estate, commodities, notes, etc). But when it comes to putting money in the market, we can generally generate the most wealth if we do it without their help and their hands in our pockets.
Here are the biggest reasons why.
Financial Professionals Are Expensive
Every dollar we give to a professional is a dollar less we have accumulating interest and working on our behalf. Investors who buy commission based mutual funds from salesmen or hire a money manager to select their investments give up a lot of their dollars and have a lot less money working for them. And just as our money compounds over time, so also do the fees. That’s why seemingly small fees can have a huge impact on our future savings.
Conflicting Incentives Between Investor and Professional
Oftentimes, financial professionals’ incentives don’t map well with the investors. Investors want the best net returns but those are rarely the investment products that pay advisers the healthiest commissions.
Limited Product Offering
Most financial advisers can only offer certain investments due to their lack of experience or the companies they are contracted with. More often than not, the best investments aren’t even on the table. It’s like going to a steakhouse and only being offered chicken and salad for dinner.
Same Access to the Same Investments.
Contrary to what most people think, we generally have the same access to the same investments the professional money managers have. When we pay them to invest our money, we are essentially paying them hundreds or thousands of dollars to click a few buttons we could and should simply push ourselves.
Investing Yourself is Simple, Inexpensive, and Not Time Consuming.
No matter what the financial “gurus” claim, investing in the market doesn’t have to be complicated, expensive, or time consuming. In fact, the investments that generate the highest net returns to investors are inexpensive, simple to set up, and take very little time to manage.’
The Best Way To Invest In The Market
So if hiring a professional and buying actively managed mutual funds isn’t the answer to investing in the market, then what is?
The obvious answer is that it depends. It depends on your situation, on what you’re trying to accomplish by stashing money in the market, how long you’re planning on holding it there, how comfortable you are with the inevitable ups and downs of the market, and much, much more.
But for the vast majority of investors, index funds are the ideal choice.
An index fund is a diversified portfolio built to mimic the performance of a specific market index, such as the S&P 500. When you buy one share of an index fund, you are essentially buying a piece of every company within that index.
In a letter to shareholders, Warren Buffett, one of the greatest investors of all time, said the following:
The goal of the nonprofessional should not be to pick winners—neither he nor his “helpers” can do that—but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.
Warren Buffett recommends index funds and so do I. My recommendation is founded on four bedrock principles inherent in index funds: (1) Index funds are inexpensive; (2) historically, they have generated strong returns; (3) they reduce risk for investors; and (4) they are simple to setup and easy to manage.
Index Funds Are Inexpensive
As we discussed earlier, index funds are 20 times or 2,000% less expensive than actively managed mutual funds. And when you take the cost of taxes into consideration, mutual funds become 30 times or 3,000% more expensive.
Now in order to understand why this is such a big deal, let’s use a little example. Four friends, Matthew, Mark, Luke, and John each had $100,000 to invest. All of them generated the exact same 7% per year return for 30 years, but they all had different fees.
- Matthew invested in a taxable account that had average fees of 4.17% per year
- Mark invested in a tax advantaged account that had average fees of 3.17% per year
- Luke invested in tax advantaged funds that only charged an average 2% per year
- John invested using index funds that that cost an average of 0.5% per year
Let’s see how each of the friends fared after 30 years:
- Mathew: $230,991
- Mark: $308,806
- Luke: $432,194
- John: $661,437
There is no such thing as “low fees” when it comes to investing! FEES MATTER! These friends invested the same amount, for the same time, generating the same pre-fee returns, but John was able to amass more than $400,000 or nearly three times as much as Mathew.
This depiction may be more telling:
Index Funds Have Generated Strong Returns
As we discussed above, 96% of mutual funds fail to beat the market over a sustained period. So rather than attempting to beat the market, index funds match the market’s performance, and historically, the market has performed well for investors. Here’s a summary of the average returns the market has generated over the past 30 years and the impact it would have had on $1,000 invested:
Yes, there have been some major ups and major downs in the market and historical performance is no guarantee of future results. But I think the risk of an unsure future is worth the possible reward. And an index fund is so far the best tool to capture as much reward as is possible.
That’s why David Swensen, manager of Yale University’s $23.9 billion endowment observed: “When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.”
Index Funds Reduce Risk
Index funds are also one of the greatest tools to reduce the risk inherent in investing. You’ve heard the old adage “don’t put all your eggs in one basket.” A well constructed portfolio of index funds are the epitome of that statement when it comes to investing in the market. In the investing world, it’s called diversification.
When you buy one share of an index fund, you are essentially buying a piece of all of the companies within that index. For example, a large portion of my retirement savings is in VFIAX (a Vanguard S&P 500 index fund). Every time I buy a share of VFIAX, I am buying a portion of Apple, Microsoft, Amazon, Facebook, Warren Buffett’s Berkshire Hathaway, and 495 other companies.
Now there is a chance of all of the companies failing or doing miserably financially, but the chance of that happening is far less than the chance of a single company’s stock going bust. When you diversify and buy a piece of many different companies, you are limiting your exposure from any single company’s stock depreciating.
Please note that this is only one level of diversification, and I recommend diversifying among many different asset classes (i.e. bonds, stocks, real estate, etc.), regions, and markets, including assets outside of the typical stock and bond markets. You can use indexing to diversify deeper by indexing bonds, real estate investment trusts (REITs), and many more asset classes both domestically and internationally.
Index Funds Are Simple To Purchase, Setup, and Manage
Another benefit of Index funds is how simple they are to purchase, setup, and manage. There are really only four steps needed to invest in index funds.
1. Select a Brokerage. There are many different brokerage firms, but the three most important consideration in determining which firm to use is (1) whether or not the firm offers low-cost index funds, (2) whether the firm’s investment platform and interface is user friendly, and (3) whether the brokerage firm is well established and respected. The three firms I recommend to look into are Vanguard, Charles Schwab, and Fidelity.
2. Select the Type of Account. There are various types of accounts you can use to invest, and you need to select which one aligns best with your investment objectives. You can select an individual retirement account (IRA), which offers tax advantages for those saving for retirement. You can select a college savings account such as a 529 plan, which depending on your state, may offer some great tax saving benefits. Or you can also use a typical brokerage account, which allows you to buy and sell as you please without penalty.
3. Purchase the Fund or Funds. There are many different index funds, so here are three of the most important questions to ask to help ensure you buy the right fund.
- What is the expense ratio? Index funds’ expense ratios range from 0.05% to 1.6%, but anything over 0.25% is too high. Only consider funds less than 0.25%.
- How has the index performed? I generally use the S&P 500 as my benchmark to assess how well index funds perform. I want my funds to perform as well as the S&P 500. If they don’t over a 5 or 10 year period, they are generally not worth the risk.
- How much diversification is the fund giving you? The Dow Jones Industrial Average will give you 30 of the largest companies in the US, the S&P 500 will give you 500 of the largest, and the Russell 2000 will give you exposure to 2,000 small-cap companies. Most likely, you’ll need to select multiple funds in order to adequately diversify your portfolio. For example, you’ll most likely want to select an index fund for domestic stocks (large & small cap), another for international stocks, and another fund for bonds. Generally the more diversification, the better, but you must weigh it with the other two questions above.
4. Automate Your Contribution. The final step is to set up an automatic deposit into the funds you purchase. For example, once a month have your brokerage draw from your checking account and purchase more shares of the index fund. Doing so enables you to take advantage of one of the most powerful principles in personal finance—automation. When we automate our savings, our wealth grows with us having to do little to no work.
Buying index funds is simple and you can do it. But if you’re still unsure and want to consult a professional, I recommend using a fee-based advisor that recommends index funds. If they don’t recommend index funds they probably don’t have your best interest in mind. At the bare minimum, index funds should be at the heart of your retirement savings for your funds that are allocated to the market.
Most of us hire professionals and buy actively managed mutual funds to invest in the market, but index funds offer a much better alternative. While speaking of index funds, Jack Bogle, founder of Vanguard, said they provide, “maximum diversification, minimal cost, and maximum tax efficiency, low turnover, and low turnover cost, and no sales loads.” All of these benefits boost the net returns each investor is able to generate.
Open up an account with a brokerage firm and start buying index funds!
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