According to data published in Allan Roth’s How a Second Grader Beats Wall Street, a typical actively managed mutual fund has about a 38 percent chance of beating an appropriate index in any given year. Over five years, that falls to 22 percent, and after 25 years (a typical physician career length), it is just 1 percent. In a five-fund portfolio, the chances are even worse, about 20 percent in any given year and 7 percent after five years. The solution to this dilemma is to avoid playing the game at all despite all the time, effort, and money spent by financial institutions trying to get you to do so.
Explore This IssueACEP Now: Vol 33 – No 07 – July 2014
Step 3: Capture the Market Return
There is another category of mutual funds called passive funds, which simply try to capture the market return rather than beat it. Most of these funds are index funds, which try to match the market return rather than beat it. The main reason index funds have better long-term returns than the vast majority of actively managed funds is that it costs a lot of money to try to beat the market. You have to hire a small army of analysts to meet with company executives and pour through earnings reports. The funds also spend a lot of money on commissions and bid/ask spreads every time the manager decides to buy or sell an investment. Unfortunately, it turns out to be very difficult to generate sufficient excess returns (returns above and beyond what an index fund will provide) on an after-expense basis.
However, because index fund managers just have to match the market return, they rarely have to buy or sell anything and certainly don’t need to spend money on analysts. It can be very inexpensive to run index funds, often less than 0.1 percent per year ($10 on a $1,000 investment). Index funds are also inherently tax-efficient due to their lower turnover. If the asset class you are trying to invest in is U.S. stocks, you want the investment that will best capture the return of that market—a passively managed fund that owns all of the publicly traded stocks in the United States or at least a statistical representation of them. Accepting that market returns are likely the best you are going to get is the counterintuitive first step in becoming a successful long-term investor.
Step 4: Keep Costs Low
Once you realize that active management is a loser’s game, your focus should shift to those things you can control, like investment expenses. In investing, you get what you don’t pay for. If you are paying 2 percent per year in advisory and management fees, that 2 percent is subtracted from the market return, and over the long run, expenses that high will transfer more than 50 percent of your eventual wealth from your pocket to Wall Street. A portfolio of index funds can be managed for just 0.05–0.20 percent per year. There is no reason to pay five times that much, much less 40 times. Mutual fund fees come in many flavors. The most visible one is the expense ratio, which is the cost of running the fund divided by the value of the assets in the fund. Every fund has an expense ratio, although they vary from 0.02 percent per year to more than 100 times as much. Many mutual funds also charge an additional marketing, or 12b-1 fee, which is often around 0.25 percent. There is no benefit to you to pay such a fee.