I often ask my clients two questions to help them obtain a low-cost stock investment strategy: What level of return are you seeking and how much should you pay to buy that asset? Of course, these two questions come after you have decided on your investment horizon (http://www.financialadvisorforyou.com/how-should-i-invest-my-money/) and risk tolerance (http://www.financialadvisorforyou.com/2-reference-points-can-help-you-assess-your-risk-tolerance/). The short answer is that index funds, which mirror the market, are one of the best ways to achieve solid long-term investment returns at a low cost.
What Level of Return are you Seeking?
Do you want to pick stocks that try to beat the market’s average return or are you happy with the returns of the market? Stocks on average have earned 10.2% each year over the past 88 years (of course with some years being better than others and many years at a loss). These are not bad returns. And as these recent headlines show, professionals money managers do not beat the market on a long-term basis: “Another Flop for Mutual Fund Managers” (Business Week, December 18, 2014) discussing how the “smart money” did not buy Apple this year, but it raised 33 percent thru December 16, 2014 (http://www.bloomberg.com/bw/articles/2014-12-18/mutual-fund-managers-2014-is-another-flop). Or earlier in the year, “Successful Mutual-Fund Managers Beat The Competition. Very Few Beat The Market” (Forbes, August 7, 2014) describing recent academic research that mutual-fund managers do not outperform the overall market (http://www.forbes.com/sites/danielfisher/2014/08/07/winning-mutual-fund-managers-beat-the-competition-not-the-market/).
So you may want to ask yourself whether you want a broker to pick stocks for your portfolio (or have an actively managed mutual fund or Exchange Traded Fund that picks stocks) or would rather have a mutual fund that mirrors the overall market. The funds that mirror the market are called “index funds” because they follow or copy an index of the market. One of the most popular is the S&P 500 which tracks the performance of the 500 large domestic companies. You can purchase these funds from low-cost brokerages such as Vanguard, Charles Schwab, or Fidelity. There are other popular index funds that track the overall domestic stock market, the overall international market and many submarkets within each of these broad categories (large companies, small companies, companies in emerging markets, etc.).
If recent money movement is an indication, most investors have opted for the later approach. Indeed, consumers have heard this message. Look at this headline from the Wall Street Journal “Vanguard Sets Record Funds Inflow Investors Gave Stock Pickers a Vote of No Confidence in 2014” (January 15, 2015). http://www.wsj.com/articles/vanguard-sets-record-funds-inflow-1420430643 The article describes the strong trend away from mutual funds with active management toward funds that mimic indexes or other benchmarks. In 2014 actively managed funds actually had more money pulled out (than put in) while index funds had a record amount put into them. The upshot is that better long-term returns are gained through passive stock mutual funds and ETFs.
How much are you Paying to Buy Your Funds?
Actively managed funds have higher expenses than passively managed index funds or ETFs. There is no stock picking and research expenses for passively managed funds and ETFs. Rather it uses computer algorithms to buy and sell stocks to approximate the market index it is following. Thus their expenses are lower and your return is higher!
So unlike many things, you don’t get more by paying more. In fact, paying more for an actively managed fund takes away from your earnings. So I always ask why purchase a fund with a 1.0% expense rate that invests in large domestic companies when you can buy an index fund with 0.1% expense rate? The expense rate is already deducted from the fund’s return. So over time, saving 0.9% in fees each year on a $100,000 investment will add up to over $33,000 in lost income over 20 years (assuming a meager 6% annual return). This is real money!!
So remember for long-term investments, a low-cost stock investment strategy means choose low-cost index funds. Expenses matter and the professionals have not consistently beaten the market, so it’s not worth paying for it. You should keep your hard-earned dollars.