2014 / Investing
3 Reasons Why Active Investing Makes You a Loser
Humans are usually logical creatures when it comes to money. If we are offered a raise at our current job without any increase in workload, we’ll take it. If we see a 50% off sale for a home appliance we really need, we will try to take advantage of that sale before it goes away. If we see a product is selling less online than in the store, we’ll get it online and save the time and money it would take going into the store to buy it. But for some reason, logic and reason go out the window when it comes to investing.
When most people think of investing, they think of people screaming and throwing paper at each other in New York City. They think of all the financial doom and gloom they hear on the airwaves when an international incident happens. Most people say they don’t have the time to learn how to pick stocks. But what if I told you that the S&P 500 Index, which tracks some of the countries’ biggest companies, has grown from about 1100 points 10 years ago to 2000 points today (nearly double!), despite a massive recession in 2008?
And that’s exactly what recent research by the S&P Dow Jones Indices has shown. The vast majority of actively managed index funds could not meet the performance of their S&P benchmark over a 5 year period. Some active funds will do well for a year or so, but quickly fall back down to Earth, usually with a thud. It has been shown time and time again that actively trying to pick stocks, in essence trying to time the market, will very likely leave you poorer and more frustrated than simply investing in an index fund and letting it grow. Here are 3 reasons why:
1. Lower returns
As this most recent study and many other studies have shown, if you’re indexing for anything longer than a year you will have a great chance of outperforming almost every actively managed fund out there. The numbers don’t lie and these are the numbers that the media and big fund companies won’t promote. Actively managed funds are the darlings of the investing world and their managers can sometimes take on a god-like status. Don’t fall for the charade and sacrifice returns on your hard earned money.
2. Higher costs
As the saying goes, “if you want to cross the bridge, you have to pay the toll.” There is a cost to doing business and this cost could be costing you BIG money when all is said and done. There are many administrative fees associated with both active and passively managed mutual funds. But the costs are usually much lower for passive funds. The most common metric used to show the overall cost of a fund is the expense ratio. This is how much of your money is taken from your portfolio each year in order to keep the mutual fund operating. For actively managed funds, most of this money goes to the managing team. Since a passively managed fund doesn’t really have a hands-on management team, by definition the expense ratio will be much lower. As an easy example, a $500,000 portfolio in an actively managed fund with an expense ratio of 1% (which is on the low end for an actively managed fund) will cost the investor $5,000 for the year in fees. That same portfolio in a passive fund with an expense ratio of 0.2% (some funds have ratios much lower than this) will cost the investor $1,000. That’s a $4,000 premium just having your money parked in an actively managed fund which is probably performing worse than the passive fund. Sounds like a lose-lose proposition.
3. Unnecessary stress
Investing in an index fund that tracks the S&P, for example, requires very little attention and brainpower. It just takes emotional strength. As long as you’re investing for the long term (and you all are. Yes - even you baby boomers have to make sure your money last over the next 20 years), you don’t really have to worry about recessions and corrections too much because markets are resilient. Investing in an index fund requires very little maintenance. You’ll have the luxury of tuning out the noise you hear on radio and TV and will actually be able to focus on life.
In an actively managed fund on the other hand, you’ll have to be monitoring your situation regularly. If the fund manager so much as sneezes twice, you’ll have to reconsider the health of the fund going forward. You’ll also have to keep an eye on what the fund is investing new money into make sure it’s in line with your goals. If performance has been abysmal the past few years, which is commonplace with active funds, then you’ll have to worry about finding a new mutual fund, doing a bit of market timing in the process. And seeing your fund manager buying nicer and nicer cars while returns are lower and lower doesn’t seem very reassuring either.
The moral of the story is to set a global allocation, be an owner not a loaner, diversify with index funds, and be patient and disciplined to these principles.