Month: March 2017

What are Index Funds?

According to Bill Schultheis, author of The Coffee House Investor, active managers constantly and consistently underperform the stock market average for two main reasons:

First, the stock market average is already very efficient. In a broad sense, the market does reliably well. The better it performs, finding ways to “beat” it proves more challenging to near impossible.

Second, your “managed” investment will suffer from substantial annual expenses, which, of course, reduce your total return.

Since the stock market average has historically provided an already-exceptional investment return, odds are that when you try to beat it, you will fall below it. And what a shame that is to the investor who could have easily spent far less, both financially and mentally, to return the relatively superior stock market average.

What’s the solution? A passive investment approach that aims for the stock market average by using unmanaged index funds.

It’s simple.

A stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index. Instead of stock-picking, you invest in every stock. By doing so, investors are able to most reliably secure the approximate stock market average in their returns. There’s no need for management (besides passive quarterly inspection/infrequent rebalancing according to preferred asset allocation), because a piece of every stock is purchased. This eliminates the burden of active stock-picking or hiring a “professional” to do so—and consequently enhances your quality of life significantly.

Moral of the story? History shows that investing in the creativity of all human beings equally is actually more profitable, on average, then investing with a mutual fund manager who promises to beat the stock market by selecting the “best” companies to invest in. It also happens to be simpler, less time-consuming and stress-inducing, and much cheaper to do so by means of low-cost, unmanaged stock index funds.

As a final note, consider Pascal’s Wager and its wisdom here; would you rather invest in the entire market to secure a comfortable return that beats most mutual fund managers, foregoing great returns accompanied by great risk, or invest selectively with “professionals”, aiming for great returns, yet most likely falling short of the average? The choice is yours.

 

Key Takeaways

  • Active managers constantly underperform the stock market average return because the stock market is already very efficient and their fees and expenses reduce your total return.
  • Low-cost, passive index funds are the easiest and most cost-effective vehicles for returning the stock market average
  • A stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index, thereby approximating the stock market average in its return
  • These index funds are “passively managed” because, besides infrequent monitoring and annual rebalancing according to preferred asset allocation, investors never have to manage these funds.

 

Munir Gomaa is a 3rd year dental student with a passion for personal finance, self-improvement, and human psychology. He can also be found blogging at munirgomaa.com

 

Click here for related post, “Understanding the Market.”

Understanding the Market: Part 1

[editors note: We are starting a new series entitled “Personal Finance 101″ to act a primer for various personal finance topics so as to build a foundation for you that you can then use to navigate “Muslim-friendly” approaches. Enjoy!]

Discover the key to stress-free, reliable, and successful investing

What if I told you that the “best” stock investment advice—meaning the safest, simplest, mostreliable, and most successful advice, according to over an entire century of data—that you can find is completely free? What if this advice could be easily applied to your entire portfolio without the help of an active manager?

Wall-Street wants you to believe that this is complete and utter nonsense. That’s because Wall-Street’s actively managed mutual fund industry’s profitability—and in turn, its clients’ financial decline, depends on you ignoring this advice.

You see, the active mutual fund manager’s profitability does not necessarily correlate with your own, despite their employment obligation to convince you otherwise. Let’s make everyone’s objectives clear:

Your goal: to receive a significant, reliable, net positive return on your investments in the stock market to supplement your portfolio, “beat” inflation, and secure a comfortable retirement.

Their goal: to maximize assets under management (AUM), because the more of your assets being regularly “managed”, the more fees and transactional expenses they receive directly from your pocket. This, on average, lowers your return by 2% (2010 Bernstein, The Investor’s Manifesto), meaning that if your portfolio returned 10%, you’ve only acquired 8%.

Sure, these active fund managers will spend their busy work schedules trying to analyze interest rates and predict future company earnings to pick the “best” specific stocks, industries and mutual funds. They use past performance, of course, to make these predictions. But history has shown us time and again that past performance in mutual funds has little to do with its future performance, and that stock-picking to beat the “stock market average” is a nearly hopeless mission. In fact, at the time The Coffee House Investor, by Bill Schultheis, was written, 86% of active mutual fund managers failed to beat the stock market average return in the three, ten and fifteen years prior (1998 Schultheis, The Coffee House Investor).

What exactly is the “stock market average”? It’s the averaged collective return of all publicly traded companies included in any particular index (i.e S&P 500). The return realized from the good companies and the not-so-good companies altogether. And guess what? This collective “average” historically outperforms most actively managed mutual funds.

In general, the stock market average reliably outperforms 75-85% of all actively managed mutual funds. 

The logical implication here, of course, is that the wise investor should aim to return the stock-market average–nothing less, nothing more. As it turns out, doing so is also the simplest and least stressful way to invest, and it is done via low cost, unmanaged index funds.

 

Key Takeaways

  • Your financial and retirement goals are not in alignment with Wall-Street’s goals
  • Your goal is to maximize investment returns and secure a comfortable retirement
  • The goal of an active mutual fund manager is to manage as many of their clients’ assets as possible to maximize fees and transactional expenses, lowering their clients’ returns significantly
  • Past performance of mutual funds or individual stocks has little to do with future performance, and trying to beat the stock market is comparable to gambling
  • The stock market average, the averaged collective return of all publicly traded companies included in any particular index, historically outperforms actively managed mutual funds
  • Wise investors should aim to receive the stock market average in their returns

 

Click here for Part 2.

 

Munir Gomaa is a 3rd year dental student with a passion for personal finance, self-improvement, and human psychology. He can also be found blogging at munirgomaa.com