Beginning Investing #6: Use Index Funds


Picking individual stocks may be fun and exciting, but it usually generates a much lower return than simply investing in low-cost, index mutual funds.

Four Options

If you’re going to invest in stocks, you basically have 4 options:

  • Pick Stocks Yourself.  You can decide, for yourself, in which individual stocks you’ll invest.
  • Use a Broker. You can pay your stock broker a fee (i.e. commission) to pick stocks for you.
  • Mutual Funds.  You can pay a mutual fund manager a fee to actively select stocks for you. The annual fee is typically 1% - 2% of your investment.
  • Index Mutual Funds.  Index mutual funds simply invest in most or all stocks in their respective market index. Fees are much lower, typically 0.05% - 0.50% each year.

Picking Stocks is Like Gambling

Here is a key point:  No one consistently picks winning stocks. Read that sentence again, and let it sink in. Even investment professionals—including stock brokers and mutual fund managers—can’t consistently pick winners.  

In a sense, picking stocks is like gambling. It can be exciting, and sometimes you even win. But over the long run, you likely lose more than you win. (How do you think they pay for those fancy casinos?)

And paying someone else (e.g. your stock broker) to pick stocks for you is like paying someone to go gamble for you. It is basically throwing money away. Your stock broker may be a wonderful person, and may provide valuable advice about how to manage your finances, but they possess no special, consistently accurate insight regarding the future price of any particular stock. Remember that brokers make money on your trading activity (i.e. when you buy or sell), not on whether you achieve a good return on your investments.

Active Mutual Funds

Mutual fund companies hire managers whose job is to actively select and invest in stocks for a large group of people. Typically these managers charge a fee of 1% - 2% of your asset base each year. So if you invest $100,000, they will charge you a fee of $1,000 - $2,000 each year.

As a group, it is impossible for these mutual fund managers collectively to beat the market, because they are the market. Professional investors (e.g. mutual fund managers) account for about 90% of all stock market trades. So as a group, mutual fund managers earn the market return. But since managers extract an average 1.5% fee, the mutual fund and its investors earn 1.5% less than the market, on average.

As a result, very few mutual funds beat the market return despite the hefty fees investors pay (in hopes that the mutual fund will beat the market). According to one study, only 2% of mutual funds significantly outperformed the market over the 30-year period, 1972-2002.[1]

Performance           Percentage of
vs. Market               Mutual Funds

-2% or Worse                    16%
-2% to Zero                      57%
Zero to +2%                     26%
+2% or Better                     2%

Approximately one third of mutual funds outperform the market in any single year. But as the time frame lengthens, the fraction of mutual funds that beat the market declines. For 10-year periods, only one quarter beat the market; over 25 years, only one tenth beat the market; and over 50-year periods, only about 5% beat the market. So your odds of picking a successful mutual fund, i.e. one that beats the market over the long term, are quite small.

You might think, “I’ll just pick a fund that did well last year.” But studies show that last year’s mutual fund ‘winner’ typically underperforms the following year. It is just as hard to predict which mutual fund will win as it is to predict which stock will win!

Index Mutual Funds

One way to successfully invest is with no-load, low-cost index mutual funds. (A ‘load fund’ charges an up-front fee of as much as 6% of your investment. Avoid these funds.)  Examples of no-load index funds include Vanguard’s Total Stock Market Index fund (ticker = VTSMX) or Schwab’s S&P 500 Index fund (SWPPX).

Index funds don’t bother trying to identify winning stocks; instead, they aim to achieve the market return simply by investing in most or all stocks in their respective market (e.g. all U.S. companies, or small companies, or growth companies, or foreign companies). Their fees are typically much lower, about 0.05% - 0.50% each year, because they don’t need to hire expensive stock analysts. Index fund investor generally achieve very close to the market return (something most mutual funds don’t achieve) at a much lower fee.

Still not convinced?  The book, Common Sense Investing, explains that mutual fund investors typically achieve a return much lower than the market.[2] The data below is for the 25-year period 1980-2005.

12.5%    Average Stock Market Return, 1980-2005
(1.5)%        average expense ratio for mutual funds
(1.0)%        commissions, bid / ask spread, portfolio turnover, etc.
10.0%    Average Mutual Fund Return

(2.7)%        poor market timing, chasing “hot” funds, excessive trading
 7.3%     Average mutual fund Investor Return

For comparison, the average low-cost index fund return was about 12%. The point is that investors are significantly better off to: i) invest using low cost, no load, index funds; and ii) hold them for the long term.

For more on this simple index fund investment strategy, I highly recommend the short book titled The Elements of Investing, byBurton Malkiel and Charles Ellis.


Footnotes

[1] Charles D. Ellis, Winning the Loser’s Game: Timeless Strategies for Successful Investing, 4th edition (New York: McGraw Hill, 2002), 104-105.

[2] John C. Bogle, The Little Book of Common Sense Investing (Hoboken, NJ: John Wiley & Sons, 2007), 44, 51.