If You Don’t Want to Do Research, Then Use Index Funds
By Carl Lachman, CFP®, MBA
Indexing Questions Are Common in Orange County
When we meet with people who are interested in our fee-only financial planning firm in Fullerton, California (located in the northern part of Orange County), they often ask us if we use index funds in our clients’ investment portfolios. We answer that we occasionally use index funds, but usually we do not. If you are willing to spend the time looking, we explain, usually there is something better available.
Index Funds Get a Lot of Press
Articles about the simplicity, low expenses, and power of index mutual funds are common in the financial press. What is not to like? They are low cost and track with the performance of the stock market. They are often presented as the best solution for securing one’s retirement.
Index Funds Track a List of Investments
Index funds are made up of a group of stocks or bonds tracking with a published market index. The Standard & Poor’s list of the top 500 stocks in the United States is the S&P 500 Index, which is a common index for mutual funds to track. Other common indexes are the Dow Jones 30, the Russell 2000, the Barclays Aggregate, and the MSCI EAFE international stock index.
An Idea from Jack Bogle
Jack Bogle founded The Vanguard Group and created the first index fund in the mid-1970s. He wanted to allow people to invest in a group of stocks through a mutual fund without the need for a portfolio manager. He found evidence that the average mutual fund manager did not do better than the stock market as a whole, so he thought it would be better to just invest in a passive manner and save the cost of a manager.
Warren Buffett Also Likes Index Funds
One of the most famous stock market investors is Warren Buffett, who often suggests that average individual investors use a cheap S&P 500 mutual fund for their retirement savings. He even made a winning $1 million bet once that an index fund would perform better than a group of hedge funds over 10 years.
Where Does Warren Put His Money?
Most of Warren Buffett’s billions are invested in the stock of the conglomerate company he controls, Berkshire Hathaway. Berkshire Hathaway, in turn, buys whole companies or the stock of companies that Buffett thinks are going to be successful and more valuable in the future. While he talks about the benefits of index funds, Buffett’s own money is in individual stocks or in whole companies. Why is that?
Warren Is Willing to Do Research
The average day for Warren Buffett involves lots of reading. He reads financial newspapers and the annual reports of companies. He also calls companies directly and asks questions of financial officers and managers.
What is he doing? Research. He finds as much information as possible about companies he is thinking about investing in to see if they will be a good investment. In fact, he generally is known to organize and discipline his whole life around researching companies. He does this because he discovered a long time ago that if you are willing to do the research, you can find good companies in which to buy and invest.
There Is Usually a Better Investment Available
An average investor who doesn’t want to do any research will get an average return if they use a stock index fund. But, if you are willing to do the research, then you can usually find a mutual fund that has done better than that index. It is true that the majority of mutual funds do not do better than indexes, but even a little research shows that many active managers of mutual funds outperform indexes over not only short periods of time but also for long periods.
We’re Hired to Do the Research
Our clients are smart people and they have figured out that, while they don’t want to spend their days researching investments, they can hire professionals like us to do the research for them and also eliminate a lot of the administrative hassles that come with finances. Our fee-only financial planning firm is staffed with experts in researching investments. According to a recent study, fee-only financial advisors potentially add 3% per year in net returns to client investment portfolios. Considering that fee-only advisors charge an average of 1% of the assets they manage per year, most clients usually come out ahead using a fee-only advisor.
Aren’t Active-Management Mutual Funds Expensive?
Generally, it is true: Active-management mutual funds are expensive to the average investor. This is usually because investors are paying commissions (loads) on those funds and not paying attention to the annual fees. If you use a financial advisor who doesn’t get paid any commissions, then there should be no loads on the mutual funds.
A fee-only financial advisor will use only “no-load” mutual funds. Plus, if that fee-only financial advisor is researching the mutual funds, they will find well-performing mutual funds with low annual expense ratios. A fee-only financial advisor has no incentive to use mutual funds with expensive management fees, so they will choose the lower-cost funds and ETFs (exchange-traded funds) that are available.
Indexes Get All the Up, but Also All the Down
Sometimes people are concerned that their investments are not going up with the stock market, so they see index funds as the answer. Stock index funds that track large cap stocks, for instance, will go up as fast as that group of large cap stocks. People forget, however, that the same large cap stock index fund will go down as fast as that group of stocks, too. There are no brakes on an index fund investment vehicle.
Active management mutual funds, however, have portfolio managers that can move money to conservative investments like cash if they fear that there is going to be a drop in the market. Our company’s client portfolios may lag while the stock market is going up, but they don’t usually go down as much when the market drops. Good mutual fund managers often change their portfolios to try to preserve value when the market is in a down cycle.
Low Costs Plus Diversification
Not only does a good advisor look for low-cost mutual funds, but they also seek broad diversification by understanding what is in the mutual funds we recommend to our clients. Choosing an S&P 500 index fund for the long term is a good first decision for investors who don’t want to do any research, but it isn’t the last decision they should make.
They also need to decide on an allocation, such as how much to invest in international stock markets and bonds. An investment portfolio that can weather the unpredictable ups and downs of the financial markets needs to be diversified into stocks and bonds, domestic and international markets, large cap and small cap stocks, and alternative investments.
If You Want to Be Better Than Average …
So, if you want to skip investment research and get average returns, then you should use index funds. But, if you want the chance of better-than-average returns over the long run, then plan on doing a lot of research or hiring a fee-only advisor that will do the work for you.
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