While I certainly don’t think that all actively-managed funds are poor investments, I am firmly convinced that most investors would be better off using index funds instead.
Why? Because of costs.
It’s simple math, really.
Let’s imagine that over the next decade, all the publicly owned companies in the world economy earn a grand total of $800 trillion. As a result, the most that all of the shareholders of those companies could earn on their (stock) investments over the decade would be $800 trillion. Simple so far, right?
However, in reality, the total amount earned by the whole group of investors would be significantly less than $800 trillion. Why? Because of investment costs–things like brokerage fees and commissions, mutual fund sales loads, mutual fund operating expenses, and so on.
In fact, the total amount earned by investors will be precisely equal to the total amount earned by all the public companies, minus the grand total of the investment costs incurred. Or, to put it mathematically:
Total Return for Stock Investors = Total Stock Market Return – Total Cost of Investing
The less investors pay (in total) in investment costs, the greater total return we will earn. Or to be blunt: Investors would make more money (in total) if actively-managed funds didn’t exist.
How this affects you
Of course, the real question is whether you will make more money by paying a fund manager to select investments for you as opposed to using an index fund that simply holds every stock in the index. And the answer, of course, is “you might.”
…but it’s unlikely.
Why? For precisely the same reason, actually: investment costs. Let’s say that over the next decade, the stock market earns a 10% rate of return, and investors on average pay investment costs equal to 1.5% of assets. In this scenario, the average dollar invested will earn a return of 8.5% (10% – 1.5%).
The average dollar invested in an index fund, however, would earn very close to what the market itself actually earned: 10%. (In reality, it would be closer to 9.8% after accounting for a typical index fund expense ratio of 0.2% of assets.)
In other words, while some dollars invested in actively-managed funds will beat the market, most of them won’t.
An analogy
Try thinking of it this way: You have a hat in front of you. In it are scraps of paper with the numbers 1-99 written on them. You are given two options:
- Pick a scrap of paper without looking, and you will win an amount of money equal to the number on the paper. Pull a 20, win $20. Pull an 87, win $87. Or…
- Win $77 automatically.
Taking the $77 obviously puts you ahead for 76 out of 99 possible outcomes. Similarly, index funds are shown in study after study to outperform greater than 60% of their actively-managed peers. (The 77% number came from this article.)
What do you think? Want to pick a number?
Want to learn more about investing?
Enter your email address to receive free updates from this blog. (You won't receive any emails other than blog posts, and you can unsubscribe at any time.)Like Cliffs Notes...for Investing
| If you're looking for a brief, plain-English introduction to investing, I'd encourage you to pick up a copy of my book: Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less. |  |
{ 4 comments… read them below or add one }
Thanks for this post! I really like index funds. You keep more of the earnings in your pocket, and they’re pretty easy to invest in. Great for beginners or for the person who doesn’t want to worry about active trading.
I feel the same way. Most investors are better of buying index funds and saving on costs.
Hi
I’m sorry if I sound naive but I’ve never invested in anything. I heard Howard from CNN suggest investing in Index Funds, Vanguard I think is what he said. But I haven’t a clue how to go about it. Also, how much should I invest and is there a fee for this investment? I don’t have that much savings, the economy isn’t all that great and I have a small boy to look after, it’s just he and I. Any suggestions?
Hi Annie.
As you can tell from this article, I obviously think index funds are a great idea for most investors (myself included).
As I explain in this article I think Vanguard is an excellent choice for index funds.
As to how to go about investing in Vanguard funds, you have two options:
This article provides some more discussion of opening up an IRA as well as links to where you can do so with both Vanguard and TradeKing (my discount brokerage firm of choice).
Hope that helps.
One last thought: Given that you’re new to investing, I’d first suggest reading a little on the topic of asset allocation so that you can determine how aggressively/conservatively you want to invest in order to best reach your goals.