There are a lot of different types of funds you can buy. So then… why index funds?

The general idea behind index funds are that they should have the lowest expense ratios and should have no load or any other hidden costs. By having the lowest costs possible, and simply tracking the market rather than actively trying to beat it, you have the highest chance of coming out ahead over the long term compared to an actively managed, higher expense ratio, loaded fund.

Remember what I said in my previous post? Just let the balls go by and collect your $26? It all has to do with that principle.

Sure, you could try to collect some home runs, but why? You don’t need to. 

So when people are all sitting around and talking about “how the market is doing” you can just tune all that out. You don’t care how the market is doing.

Is it a bear market? Or a bull market?

Doesn’t matter to you. Because as long as you follow the idea of putting away enough money into index funds and rebalancing your stocks and bonds every few years, no matter what the market is doing, you are doing what you need to do in order to be ready for retirement. Stay the course.

For example:

Vanguard Total Stock Market – Admiral Shares

This holds 3728 stocks… THREE THOUSAND SEVEN HUNDRED TWENTY EIGHTY stocks. (1/31/2016)

And it has a 0.05% expense ratio. (1/31/2016)

It really doesn’t get much better than that for a large total stock index fund.

Now let’s look at an actively managed fund.

PIMCO Total Return A

I don’t know how many stocks this carries, but I guarantee it is significantly less than 3728. (1/31/2016)

Expense ratio of 0.85%, but also a 3.75% load. This is a night and day difference compared to the above. (1/31/2016)

Let’s look at the numbers:

You invest $10000 (you have to in order to get Vanguard admiral shares)

Vanguard: No load, so you buy your $10000 worth of stock.

PIMCO: 3.75% load, so your $10000 only buys $9625 worth of stock.

Let’s say nothing changes and the market doesn’t change -at all-. Every single stock on the market was exactly the same the day you bought it and the end of the year.

Vanguard: $10000 – 0.05% expense ratio = $9950

PIMCO: $9625 – 0.85% expense ratio = $9543.19

So then $9950 – 9543.16 = $406.84

PIMCO needs to earn $406.84 more than Vanguard to make it “worth it”.

Please note that I am being extremely basic with these numbers for illustrative purposes. This becomes significantly more complex when you take into account compound interest, fees of changing funds, etc. Additionally, this gets even worse if you have pay for a “fund manager” who takes a certain percentage of your net worth every year. More on this scam later.

Rounding the numbers, this PIMCO fund would need to earn an average of 4% more than this Vanguard fund in order to do as good as this Vanguard fund.

That doesn’t seem too difficult though right? Wrong.

For an actively managed fund to beat an index fund a few years isn’t too difficult… but to do it every year for 30 years is damn near impossible.

“Over the 23 years ending in 2009, actively managed funds trailed their benchmarks by an average of one percentage point a year. If a benchmark like the Standard & Poor’s 500 returned 10%, the average managed fund investing in similar stocks would therefore have returned 9%, while an index fund would have returned 9.8% to 9.9%, giving up only a small amount for fees.” – Source

*** Past performance does not predict future success.

(You will see this on any and all paperwork a financial advisor shows you about actively managed funds.)

Of course, this still rings true for index funds as well. However, since you own 3500+ stocks, the volatility of individual stocks on the stock market mean significantly less to you.

You would have to know ahead of time which actively managed funds are going to beat the index funds every year and be able to move your money over prospectively in order to beat them over the long term. So… unless you can see the future:

Put down the bat. Let the balls go by. Collect your $26 every two weeks and go home. You don’t need to hope for a home run… you’ve already won.

TL;DR

Actively managed funds can beat index funds one, two or even three years in a row. However, it is damn near impossible for anyone to beat an index fund 30 years in a row.

Remember, no load, low expense ratios. The less you pay, the more you get.

Put your bat down. Let the balls go by. Profit.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

You don’t need to fill out your email address, just write your name or nickname.