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When we brought you The Big List of Saving and Investment Accounts last week, we promised a follow-up on the mutual fund vs. index fund debate. Don’t know what either of those are? No worries, we’ll explain. They’re super important because they are the focal point for the biggest mistake smart people make with their money.
And until last week, I was one of those smart people making this huge mistake.
What are Mutual Funds?
Mutual funds are like sampler sets of a bunch of different stocks or bonds. When you buy a share of a mutual fund, you’re automatically investing in a bunch of different companies or organizations instead of putting all your eggs in one basket. This is what investors mean when they talk about “diversifying your portfolio”. Mutual funds = automatic diversification!
Standard mutual funds are “actively managed”. This means a fund manager is actively involved in adjusting the funds to try to make them perform better than average market return rates. There is a fee for this management service. The fees averaged 0.84% of the account’s balance in 2015 (source). These fees are automatically deducted from the returns generated by your account, so you don’t have to budget for the expense to come out of your pocket.
What are Index Funds?
Index Funds are a special type of mutual fund. They work exactly the same but with one huge difference: Index funds are not actively managed. Index funds passively follow the market as a whole. For example, you could invest in an index fund that follows the S&P 500. This fund would include a portion of stock from every company on the S&P 500.
So basically Index funds just keep pace with the market; they don’t try to outperform it. That means the management fees are much lower (around 0.11% on average).
What’s the Biggest Mistake Smart People Make with Their Money?
Smart people look at mutual funds and index funds and think, “I’m smart enough to know that the highly-paid fund managers know more about investments than I do, so I’m going to pay a little extra to trust my money to the professionals.”
You assume that the better returns you’ll get from your actively-managed mutual funds will be at least enough to cover the cost of the additional fees. The problem is, they almost never are.
Research has shown time and again that most mutual funds perform worse than the market indexes. In fact, over 90% of mutual funds from 2001-2016 under-performed the market (source).
This disadvantage is made worse by the higher fees charged by mutual funds. Professor Kenneth French of Dartmouth’s Tuck School of Business found that only 2-3% of mutual fund managers performed well enough to cover their costs to the investor. The other 97-98% didn’t (source). The investors who trusted those fund managers would have been better off sticking with the low-cost index funds.
So the biggest mistake smart people make with their money is paying higher fees for actively-managed mutual funds when they could get better results with passive index funds.
Stephen Dubner interviewed Barry Ritholtz of Ritholtz Wealth Management for a recent Freakonomics podcast episode on this topic. Dubner asked, “The argument would be that […] the financial services industry is a tax on stupid people who think they’re being really smart. Do you see it that way?”
Ritholtz replied, “It’s worse than that! It’s not a tax on stupid people who think they’re smart. It’s a tax on smart people who don’t realize their propensity for doing stupid things.”
Well said, Ritholtz!
But you can see why smart people make this mistake, right? Logically, you have a fund manager making six figures, spending 40-80 hours each week analyzing the market and the stocks in the funds. How could they not beat the market average?
So Why Are the Actively Managed Mutual Funds Doing Worse than the Passive Index Funds?
How is that possible, right?! You have the best and brightest fund analyst minds actively working to beat the standard market returns. Why can over 90% of them not do it?
Well, first, fund managers don’t have a crystal ball. No one could have predicted the E. coli outbreak that crushed Chipotle stock at the end of 2015, for example.
And that’s just it: individual stocks rise and fall, but indexes consistently rise over time. A single stock could take a hit and never recover, but the market as a whole will always recover (like we saw after the Great Depression and Great Recession). If the market ever doesn’t recover, we’ll have way bigger problems to worry about than our retirement funds because the world as we know it will be crumbling. Which is oddly reassuring 🙂
One more reason fund managers can’t seem to out perform the market: they make too many moves. Think about rush hour traffic. Your lane won’t move, but the lane to your left is trucking along just fine. So you change lanes. And immediately, your new lane stops, and the lane you just left finally starts moving. You keep passing and falling behind the same semi (you know, the one you’re using to gauge your progress). You probably would have come out ahead (or at least come out the same, but saved yourself a ton of aggravation) if you’d just stayed in your lane. Same with funds. You’re better off just kicking back and enjoying the ride.
How Bad is the Loss from Mutual Funds?
Probably at least $186,640 bad if you’re investing a small-but-reasonable amount for retirement.
Let’s say you start saving for retirement at 25 years old (yay you!) to retire at 65. You invest $5,500/year and earn 7% returns on average. Side note: we’re using $5,500 is the current legal max for IRA accounts, but ideally, you’ll invest more than that IRL by taking advantage of employer-sponsored 401(k)’s (click here if you need more info on retirement accounts)!
According to our NerdWallet source calculator: With a mutual fund charging 0.84%, you’d end up with $874,145 at retirement. But with an Index Fund charging 0.11%, you’d have $1,060,785 at retirement!
Just look at the difference in how much of your investment you get to keep with Index Funds:
But that’s not all!
You know how we love to talk about the magic of compound interest, right? That’s when you make money on the money your money is making. Well, if a bunch of your money is going to pay fund manager fees, it’s no longer available to make money for compound interest to turn into more money. BOOOO!!!
What Should Smart People Do Instead?
The obvious answer is invest in low-cost index funds.
But if you’re new to investing, that can be scary. I’ve been investing for over a decade, but I’m still a bit nervous about going it totally alone (well, without a fund manager anyway; I know we’re all in this together, so none of us have to be totally alone on our finances 🙂 ). I’ve always been comforted by the idea of an Ivy-league grad in a suit in a fancy office crunching numbers for me day after day!
So statistically, passive index funds are your best bet, but you also need to be somewhat comfortable with your investment decisions. We say somewhat because, really, you need to pull the trigger on investing whether you’re totally comfortable or not. It’s the only way to grow your savings enough to support yourself in retirement.
Luckily, millennials who aren’t cool with high-cost mutual funds or purely passive index funds have a third option: Robo-Advisors!
What are Robo-Advisors?
Robo-Advisors are the computer program equivalent of a human fund manager. Super fancy algorithms actively (and automatically) manage the investments within the investor’s parameters.
Robo-Advisor fees are higher than index fund fees, but much lower than mutual fund fees. Betterment, for example, charges somewhere between 0.25% and 0.40%, depending on the size of the portfolio. And they’re currently waiving those fees for up to a year (again, depending on the size of the portfolio), so if you’re ready to move your stash from mutual funds to Betterment, now’s the time to do it!
Let’s say you’re paying 0.30% to Betterment to manage your retirement investments. Using the same financial info we used in the previous example ($5,500/year for 40 years at 7% returns), you’d have $1,008,346 at retirement. Far better than the $874,145 you’d get with mutual funds, and not too much worse than the $1,060,785 you’d have with index funds.
Oh, and another benefit to Robo-Advisors is tax considerations. New investors usually don’t think much about the tax consequences of investing. Investing can be complicated enough without all the crazy-complex tax code crap! But Betterment builds these tax code bits into their algorithms so they’ll be considered in your portfolio management. Brilliant!
Don’t make the biggest mistake smart people make with their money! Opt for Index Funds over Mutual Funds. But if you’re not quite ready to move forward without some kind of fund management, consider a Robo-Advisor like Betterment to save yourself big money in fees and still get the peace-of-mind of active management.
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Are you willing to DIY an Index portfolio or would you prefer to pay the fees for a Robo-Advisor?