The single best investment choice – Intro to Index Funds

In my last post I showed you why your long-term investments should be in stocks.  In this post I’ll tell you about what might be the only investment choice you’ll ever need.  Before we get into that, let’s go over the various options an individual investor has for participating in the wealth-creating machine that is the stock market.

Individual stocks

Picking individual stocks can be fun, exciting, and, for those of you who love to crunch numbers, very interesting.  Unfortunately, most individuals do very poorly at picking their own stocks.  We tend to buy when everybody is saying good things about the market, when prices are high, and tend to sell when everybody is pessimistic about the market, when prices are low.  Of course, this is completely contrary to the hard-to-follow stock market aphorism ‘buy low and sell high.’  To make matters worse, you’ll be competing against highly educated professionals with loads of experience and resources.  These guys do this all day and get paid very well for it.  Chances are, they know a lot more than you.

Even if you want to try and gain competency on your own, there’s a lot of work involved.  After coming up to speed by reading a TON of material on your own, you must keep up on your stock picks at least quarterly.  You should listen in on earnings calls, read the quarterly financials as they come out, and follow important news about the company’s business prospects and any major changes in its corporate management.

For those who still want to delve into the world of individual stock picking, read my primer here.

Mutual Funds

You might decide that you don’t have the knowledge, time or interest to pick your own stocks, so you might consider paying someone else to do it.  Actively-managed mutual funds are run by professional investors who try to beat the market by picking stocks.  In return, you have to pay them via an ‘expense ratio’, which is charged as a percentage of your invested assets, generally ranging from 1-2% per year.  This means that every year 1-2% of your money goes straight into the fund company’s pockets.  In addition to fees for managing the fund, some mutual funds charge ‘loads’, which are effectively sales commissions that occur when you first buy the fund (a ‘front load’) or when you sell it (a ‘back load’.)  These are often 3-5% of assets; quite a large chunk.  If you see a 12b-1 component of a fund’s expense ratio, that means they’re passing on to you the costs of promoting and advertising their fund to other potential customers.

If all those fees sound expensive, you’re darn right!  Of course, if these highly-paid managers actually beat the market (after taking all fees into account), it would be worth it.  Unfortunately, in any given year 60 – 80% of actively managed mutual funds fail to do just that.  You might then think ‘I’ll just look for the managers that do beat the market and pick their funds’.  The problem with this is that you can only look at past performance, which is often NOT a good indicator of future performance for a variety of reasons:

1) Luck – If you take 100 mutual funds, roughly half of them will underperform the market and roughly half will overperform due to sheer random chance.  (Actually, less than half will beat the market on average due to the fees we talked about above.)  Statistically, you would even expect several funds to beat the market for a few consecutive years, again, simply due to chance.

2) ‘Survivorship bias’ – Mutual fund companies know that investors (and rating companies like Morningstar) look to past performance for an indication of future returns.  Because of this, they close down funds which show poor performance, leaving only the out performers.  When you combine this with the luck factor, you realize that these ‘survivor’ funds are no more likely than the closed, underperforming funds to outperform in the future.

To take an example, pretend you were a mutual fund company that started with 24 funds.  After year 1, 12 are up, 12 are down.  You close the down ones (replacing them with new funds) and wait another year.  After year 2, 6 of the original 12 are up, 6 are down.  Close the down 6 and wait one more year.  After year 3, three funds have outperformed the market an amazing 3 years straight!  Now you heavily tout them in every investment publication you can find, inviting many investors to buy in only to see mediocre results afterwards.

3) Fund manager turnover and ‘style drift’ – Even if you were lucky enough to find a fund manager like Peter Lynch, he might leave a fund, leaving you no better off than you were before.  Similarly, a fund manager who was successfully using ‘value’ techniques might change his investing style to something that doesn’t work for him.  Many managers during the dot com bubble couldn’t resist the allure of high-growth tech companies like Cisco and Amazon.  They bought into stocks completely outside the realm of their expertise, and as a result, their investors lost a ton of money.  This switching of investing styles is known as ‘style drift’, and can make the most conservative fund more risky if your fund manager decides to ditch blue chips in favor of Russian gold mining or that new cold-fusion-developing penny stock company.

4) The market for mutual funds is pretty efficient – Let’s say you do find a superstar fund manager, the fees he commands don’t make his fund underperform, he sticks around, AND he stays on his game for profitable investing.  Now you have a sure winner, right?  Sorry, wrong again.  Good funds quickly become well known, and as a result, their prices get bid up by all the other investors clamoring to give them money.  In an efficient market, the price of the mutual fund will get bid up to the point where its returns should be on par with the general market going forward.  In fact, studies have shown that because of this overbidding of mutual fund prices, many funds with great past performances actually underperform the market going forward because investors have overestimated the fund’s worth.

This adds the following complication to successful mutual fund picking: you have to know something the majority of the market doesn’t in order to get into a good mutual fund and expect to outperform the market.

Given all these problems, it’s easy to see why actively-mangaged mutual funds underperform the market.  Jeremy Siegel, in ‘Stocks for the Long Run‘, has shown by how much these funds fall short of market benchmarks:

If we take out the ‘survivorship bias’ discussed above, we see that over a recent 26 year period, actively managed mutual funds have underperformed the market by over 1% per year.  That might not sounds like a lot, but if you invested $10,000 in 1971 at the market’s 11.55% you’d have $171.5 K by the end of 2006.  If instead you bought a typical mutual fund, you’d have $133.8 K, nearly $38,000 (22%) less!

Not only that, but if you take taxes into account, index funds perform even better.  The reason for this is that active managers are busy buying and selling stocks which generates capital gains (short and long-term) which creates taxes for you.  These taxes, not reflected in Siegel’s chart above, further depress your returns, unless your fund is in a tax-advantaged retirement account.

Now that we’ve shown that high fees from actively-managed mutual funds result in lower returns than the market, wouldn’t it be great if you could just buy the market at a low cost?

Index Funds

John Bogle of the Vanguard company set out to make it possible for investors to do just that.  While Vanguard is still the leader in low-cost index funds, many other major fund houses like Fidelity and T.Rowe Price have followed suit, giving investors myriad index choices.

Looking at recent history, from 2002 – 2007 the S&P 500 index outperformed 71% of actively-managed large-cap funds.  The S&P SmallCap 600 and S&P MidCap 400 outperformed 64% and 80% of actively managed small- and mid-cap funds, respectively, over the same time period.

There are numerous advantages to index funds:

Low fees – Since many index funds are comparable in terms of what they invest in, you need to look at expense ratios first.  A good index fund should have an expense ratio under 0.5%, the lower the better.  Vanguard’s major stock funds are currently at 0.18%, a fraction of the typical 1-2% fee charged by active  mutual funds.

Instant diversification – In addition to low costs, broad market index funds give you instant diversification.  An S&P 500 fund, for example, allows you to purchase 500 of the largest and most recognizable firms in the United States including Google, Microsoft, Wal-mart, McDonald’s, Nike and Disney.  If that’s not diversified enough for you, try a total stock market fund like Vanguard’s VTSMX which invests in over 3,000 US companies both large and small.

In addition to broad, US stock market indexes, individual investors can buy foreign index funds, sector funds, bond funds, etc.  Even though global markets have become more and more dependent on each other, experts still recommend diversifying your stocks across countries as well.  Jeremy Siegel recommends putting at least 30% of your assets into a foreign fund.  Since indexes are ‘capitalization weighted’, which means that the bigger a company is, the more the index owns of it, some investors also like to add small cap funds to their portfolio.  If you like, you can add 10-20% of a small cap index as well.

Here’s a couple of sample asset allocation schemes you could use (with Vanguard funds as examples; here’s a more general list of popular indexes), in order of simplicity:

1) Domestic market only – Total US stock market fund: VTSMX – 100%

2) Add foreign exposure – Total US stock market fund: VTSMX – 70%; Foreign stock market fund: VGTSX (= 50% European, 25% Pacific, 25% Emerging Market)- 30%

3) Add small caps – Total US stock market fund: VTSMX – 55%; Foreign stock market fund: VGTSX (= 50% European, 25% Pacific, 25% Emerging Market) – 30%; Small Cap fund: NAESX – 15%

Simplicity – It’s a piece of cake to use index funds to build a low-fee, diversified portfolio.  Best of all, you hardly ever need to check up on it (you should within 10 years of retirement at the very least.)  Just invest regular amounts in whatever asset allocation scheme you like (see above), repeat, and retire wealthy.  In addition to stocks, you can buy a bond fund for your medium-term savings (or just go with a high-interest savings account.)

Conclusions

Due to the underperformance on both individual stock pickers and mutual funds, index funds are the way to go for the vast majority of investors.  Even those who are very knowledgeable about financial markets do well to ignore the Jim Cramer’s of the world and focus on consistently building long-term wealth through a diversified portfolio of stock index funds.

“Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

Warren Buffett [courtesy of MoneyChimp.com]

[Check back later for an article on Exchange-Traded Funds (ETFs), which are another way to buy indexes, and a calculator to decide whether to buy the index fund or the equivalent ETF.]

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12 Responses to “The single best investment choice – Intro to Index Funds”

  1. A brief introduction on how to pick stocks « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] on how to pick stocks January 10, 2010 — Ward Williams So even after reading my warning, and despite all the ease, simplicity, lower risks and very good returns of index funds, you still […]

  2. Four Simple Steps for Guaranteed Wealth « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] for a low-fee broad market index fund to invest your long-term savings in; something like Vanguard’s Total Stock Market Index […]

  3. Hindsight: Looking back on the 2008 – 2009 recession « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] a policy of regular stock market investment (‘dollar cost averaging’) into stock market index funds tends to outperform other more active investment strategies.  Perhaps an even greater benefit of […]

  4. Another reason to love Vanguard: lower brokerage fees « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] Ward Williams You may already know that I’m a HUGE Vanguard fan.  Their rock-bottom index fund fees, selection, online account features, and investment philosophy just can’t be beat.  […]

  5. Stubbings Says:

    What is the best way to invest $20,000 . Short or long term?
    I’m open to all serious opinions and advice from anyone who knows there sh#t.
    Thanks

  6. On happiness and choice: mindful ways to feel better about life « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] smart choices in the present with respect to your goals and needs.  For most people, low-fee stock index funds are the way to invest for distant goals, like retirement.  If you have $100,000 in such a fund for […]

  7. Vanguard lowers fees again – switch to Admiral shares to save! « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] you have Vanguard index funds with $10,000 more in them, convert them to Admiral shares and save!  (Or switch to Vanguard if you […]

  8. Why picking stocks tends to be a ‘Loser’s Game’ « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] why professional investors fail, and will continue to fail, to beat passive indexes (which are my favorite investment […]

  9. The financial media makes me laugh out loud « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] mix of stocks, bonds, and cash (‘asset allocation‘) and buy highly-diversified, low-fee index funds and plan to hold them up until they need the money (for at least 5 years; the longer the […]

  10. 10 tips on how to get rich from Warren Buffett « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] means saving a large chunk of your income and investing in a smart-yet-unflashy way (hint: stock index funds!)  It also means forgoing what others might think of as ‘normal’ or at least highly […]


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