I don’t think you can beat index funds — I don’t mean this necessarily in terms of performance. While index funds are hard to beat even when it comes to rates of return, they’re even harder to beat in their simplicity and affordability. Index funds are a pretty low cost way of investing in the stock market and staying in it for the long term. If you want to grow your money without having to do much work as an active investor, then index investing is a good way to go. You can check out our discussion on this in the post: passive investing vs active investing.
Most people have heard of index funds and are quite familiar with them. If you’ve got a 401K with your employer, then it’s pretty likely that you’ve come across these funds as an option for your retirement money. Index funds may be a better option for you if your mutual funds aren’t beating the market.
Can You Beat Index Funds?
I want to give you a challenge. Are you ready? It’s a simple question. I want you to give me one thing in your life that can work only 20% of the time and still be considered successful. I’ve been thinking about it for a while now and can’t think of anything. If you do happen to think of something, what if you were paying somebody to provide it? Would a 20% success rate be worth paying for? This kind of track record won’t really measure up, would it?
Now to clarify, I’m going to define success as being able to beat the stock market. And in fact, statistics show that only 20% of all mutual funds actually beat the market. To make an overly general statement, this means that only 20% of the mutual funds in existence are performing at an average level, where the “average” describes the general market’s performance. I’m a school teacher and that means that 20% of mutual funds have better than a “C” on their report card.
That’s not very good is it? Especially if you’re paying extra for better results. For those expecting great returns, you may want to ask yourselves: what if your car only worked 20% of the time? You’d probably be upset with your mechanic. What if your doctor correctly diagnosed you only 20% of the time? You’d switch doctors right away. If you’re paying somebody to outperform certain benchmarks, you expect superior results.
There’s a silver lining here though. Even if your fund managers aren’t beating the market, they are probably (hopefully) getting you a better return than what you’d get from a high yield savings account or a certificate of deposit. I don’t mean to say that you aren’t making money (with these fund managers), but you’re probably not making enough.
Investing In Index Funds
If you have a choice of where your money goes, look at index funds. Index funds are similar to mutual funds but they track a stock index. An index is a collection of stocks that represent the market. The most well known index is the Dow Jones Industrial Average. This is the number that you see on the news all of the time. This index is made up of 30 stocks representing large companies like GE, 3M, and McDonald’s. This collection of stocks is what represents “the market” in this particular index. Other indexes are the S&P 500 which has 500 stocks in it and the NASDAQ Composite which is made up of technology oriented stocks.
An index fund allows you to invest in all of these stocks at the same time. They are diversified and they match the returns of the markets they are tracking. They typically charge lower management fees and can be some of the cheaper investments you can buy. You make money when the index goes up and you lose money if it tanks. You will never worry about beating or not beating “the market” because with index funds, you are already invested in the market rather than in just a single stock. Index investing is a relatively conservative way to invest in the stock market.
There’s been long standing debates here between those who believe that you can beat the market vs those who think it’s pretty unlikely that you will. I believe that if you play the market consistently, it’ll be harder for you to consistently beat the market, although it’s not impossible to be able to beat it on occasion. The more time you spend understanding and learning about investment markets, the better an investor you can expect to become. Those who want to go the easiest route will typically buy index funds.
How Do You Start Investing?
ETFs or exchange traded funds are very similar to index funds. You will need a top investment brokerage or mutual fund account to buy into these funds, and they trade exactly like stocks.
This is only a brief introduction to index funds, so go out and do some more research on your own and consider these as attractive investment vehicles. Just remember this: you shouldn’t pay somebody to beat the market only 20% of the time as this wouldn’t seem like very good value.
Contributing Writer: Tim Parker
Copyright © 2010 The Digerati Life. All Rights Reserved.
{ 8 comments… read them below or add one }
Good presentation. I would point out that the problem is fees and turnover. The best chance an individual has of beating the market is to spend a lot of time and resources researching stocks. This obviously requires a lot of expertise. Using active funds will cost over 2% when turnover and bid-ask spreads etc, are added to management expenses. This is just too big a hurdle over the long run.
It is also worth noting that it is not possible to select ahead of time the 20% that will out perform.
I have posted numerous times on this board how disenchanted I have become with the stock market and have stressed the importance of alternate investments. However, I do not think one should completly abandon the stock market either. I agree that EFTs and Exchange Traded Funds are probably the best bet if you stay in the market long term. Fees are low and they offer some diversification.
I love index funds. My personal belief is that even John Bogle does not today realize how big a revolution he started by forming Vanguard and promoting index funds. People are going to be learning in time that the rewards of indexing are much greater than most indexers realize today.
That said, there are big problems with indexing that are often overlooked. Index funds have not been around long and we just do not yet have enough experience with them to have discovered all the pitfalls.
The biggest problem is suggested by a phrase that appears several times in the blog entry — “beat the market.” You cannot beat the market with index funds but you don’t need to beat the market to do well with your investments. That point is made over and over again by indexing advocates. It’s true enough but it overlooks an essential point. When stocks are at insanely high prices (as they were for the entire time-period from January 1996 through September 2008), the market can’t beat certificates of deposit and IBonds. So why are we even talking about the market at such times other than to warn people to stay away from it?
A big problem with indexing is that it removes the investor from consideration of the profit-generation issues that make stock investing a good way to invest — indexers don’t need to study balance sheets in the way that those picking individual stocks do. This makes it easy for indexers to come to feel comfortable in a fantasy world (I don’t mean to hurt people’s feelings but I do want to make this point clearly) where the price you pay for the stocks you buy doesn’t matter. Nothing could be further from the truth. The entire historical record shows this beyond any reasonable doubt whatsoever.
If you’re going to be in the market, be in index funds. That makes perfect sense, in my view. But before buying any index funds, I think people should learn how to know when it makes sense to be in the market and when it makes sense to have nothing to do with it. Index funds perform as the market performs, and when the market is priced as it has been for past 15 years or so, that is a very big reason for avoiding investing in index funds.
Rob
Another stupid article by someone who isn’t well-versed in finance. First, the statistic that “only 20% of active mutual funds beat their index” is entirely misleading. Considering the fact that the clear majority of active funds have less risk than index funds, this is a horrible comparison. Anyone who took Finance 101 knows that risk-adjusted returns are most important. If I’m in an active fund with half the risk that goes up 7% when the stock market goes up 9%, your statistic says my fund is a failure. This couldn’t be further from the truth. The fund on a risk-adjusted basis is killing the index.
Do your research, and you will come out far ahead with active funds. Heck, ALL of the American Funds active funds just posted 10-year numbers that beat the S&P 500. ALL OF THEM! And that’s not even taking into account most of these are far less risky. Same can be said for several active fund families.
A 25-year study even showed that Vanguard’s active funds handsomely outperformed their index fund counterparts on a risk-adjusted basis.
-Ryan
It is true that it would be stupid to invest in something in which you only win 20% of the time. I want to propose that that is not the situation here. A smart person won’t lose 80% of the time by investing in mutual funds.
In order to win with each investment you make, you need to educate yourself and be mindful of the risks inherent in each investment you make. Spend some time with some key books. Start with a couple of books by John Bogle, the founder of Vanguard: Common Sense on Mutual Funds, and The Little Book of Common Sense Investing. As the creator of the first index fund, Bogle presents the case for them. One should include them as part of a portfolio of mutual funds. However, you should know that these funds don’t always beat the indices which they emulate do to timing delays and trading costs.
I want to make the case for actively managed funds as well. There is a very good rationale for positing that past performance can identify funds likely to outperform in the future. Actively managed mutual funds are decision-making machines. Their decision-making capability is the bottom line result of people, processes, approaches, and tools that they use every day to make decisions. Good machines are more likely to make good decisions than bad machines. This capability to make consistently good decisions can be inferred from past risk, return and persistence behavior. Persistence is the tendency of a fund to exceed S&P500 return at lower than S&P500 risk. A tool that provides this analysis is available at FundReveal.com and a free trial is available.
Asking whether or not index funds are better is the wrong question in my opinion. The right questions to ask are:
What is a reasonable rate of return to expect for different investments.
How do you expect to make money on your investments.
How to identify investments that have a reasonable shot of matching these expectations.
In both cases, active and index funds will offer rates of return to the investor in a passive fashion. You have no control, and all you got is “hope” that the market will go up or that you picked the right fund manager. That’s too risky IMO.
The way to go is to pick your own investments based upon reasonable assessments of rates of return and proven valuation criteria.
As one example, preferred stocks have existed for many decades. It is possible to invest in these and make 7-9% per year. Why risk your money with an “active” manager and hope he makes you money?
Index funds perform as the market performs, and when the market is priced as it has been for past 15 years or so, that is a very big reason for avoiding investing in index funds.
Actually, I think that prescription drugs are considered a huge success if they improve patient condition 20% over a placebo.