I think mutual fund investing is a good way to get started investing. I own two mutual funds currently and there are a few good ones out there, but most mutual fund managers still don’t beat the average market returns. It is for this reason that I recommend Index funds. Actually anyone who looks at the numbers and isn’t trying to sell you something will tell you the same thing.
Index funds give you the market returns
To put it simply, investing in Index funds is like buying a tiny share of each company in the market. So, for example, if you bought an Index fund that tracks the S&P 500 (which is a good choice) you would own a tiny amount of each company listed in the S&P 500.
The S&P 500 index includes 500 large companies that do a good job of representing the US economy as a whole. So, by investing in the S&P 500 index, you are essentially betting that US stocks will go up.
History can never be a tool for perfectly predicting the future, but it is about the best tool we have to work with. Historically over the last 100 years US stocks have gone up about an average of 11% a year. Some years have been down 25% and some up 40%, but averaged together they come out to about 11% a year.
What is the difference between a mutual fund and an index fund?
With mutual funds you pay a manager to pick a bunch of stocks that you (the shareholder) will be invested in. If there were more great managers out there this would be a great idea, but since the great majority of them fail to beat the market returns, index funds are a good choice.
So, by owning all of the stocks in the market rather than just the ones that most money managers suggest – you win. I know it seems crazy that most money managers with all of their education and experience still can’t beat the market, but it is the sad truth and the secret that they don’t want you to know.
The mutual fund industry secret
Mutual fund companies don’t want you to know that an Index fund will outperform most of their funds. They spend millions of dollars in advertising and number crunching to show you a chart that shows how their fund returned 13% on cloudy Tuesdays of every month except January over the last 2.4 years. I am exaggerating. A little bit, but not much.
Many work very hard and advertise a lot to convince people to buy their products, even though they are not as good as having an index fund.
Oh, and guess who pays for that advertising and the money manager’s yacht who failed to beat the market returns. Yep, you the shareholder. Which is yet another reason why index funds are so great. They don’t need a money manager since the stock-picking has already been pre-determined. Because of this, index funds generally charge much lower fees than managed mutual funds.
Can it really be that most money managers fail to beat the market?
Have you ever been stuck in traffic and realized that the lane next to you was moving faster than yours? You quickly dart into that lane, only to come to a stop while the cars in your old lane start moving faster. Then you go back to the original lane only to have the same thing happen again.
Just like staying in your original lane during a traffic jam often yields the best results, so too with investing. Many investors do the “grass is greener over there” approach. They are always chasing last year’s biggest returns. Well, many money managers in the mutual fund industry follow the same pattern. To add to it, they have to pay fees each times they “switch lanes.” Every time they buy or sell out of a security, they have to pay commissions. This ultimately comes out of the shareholder’s pocket.
Should you never buy mutual funds?
Don’t get me wrong there are some good mutual funds out there that frequently beat the market, but they are few and far between.
Oh, and be warned, most brokers you talk to about index funds will tell you why mutual funds are so much better. Examine the points of their argument very carefully. Keep in mind that most brokers make a lot more money off of mutual funds than index funds (if they even offer them) and I will let you decide.