If you've read Free Money Finance for more than 15 seconds, you know that I'm a big fan of index funds. I've posted what seems like a gazillion times on the benefits of index funds, but this post from Yahoo really gets to the heart of the matter of why index funds are better than other investment options. The summary:
Data I analyzed indicates that the vast number of [mutual fund] mangers can't beat the market after fees are subtracted from their portfolio returns. Over the 35-year period from 1971 to 2004, the average annual return on all actively managed equity mutual funds trailed the S&P 500 Index by 87 basis points a year, and the broader-based Wilshire 5000 Index by 105 basis points a year. Over long periods, this difference in return amounted to substantial differences in wealth.
This lagging performance of active managers shouldn't be a surprise; it's a matter of simple arithmetic. For every investor who succeeds in beating the market, someone else has to fall short of matching the market. When the costs (time and money) of actively picking stocks are subtracted from the outcome, those who actively engage in picking stocks must, on average, lag behind the market.
This leads to the somewhat counterintuitive conclusion that if you can form a portfolio that performs exactly "average" -- in other words, identically to the whole market -- you will outperform most actively trading investors.
This is why most academic and many professional advisors recommend that the best investment strategy is to match the market's performance. You can do this by putting your money in a fund that holds all stocks in proportion to their market value. Since these index funds do no research and little trading, the costs of holding their portfolios are extremely small, some ranging as low as 0.10 percent a year.
Yep. That's where I stand as well. I do invest in individual stocks and some mutual funds a bit as well, but most of my money is tied up in index funds. I just keep putting in more and more every month -- knowing that it's a simple, easy way to outperform most of the other investors out there.
Comments
You can follow this conversation by subscribing to the comment feed for this post.