Myth #3 Mutual Funds – Are You Investing Your Money Wisely?

The goal of the nonprofessional should not be to pick winners – neither he nor his « helpers » can do that – but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. – Warren Buffet, 2013 letter to shareholders

After Myth #1 – Human Beings Need To Eat Meat, and Myth #2 – I Have No Talent – Do You Need Talent To Be Successful? Here is the third myth of the series. I just finished reading Tony Robbin’s new book entitled: MONEY Master the Game: 7 Simple Steps to Financial Freedom and I thought it was good opportunity to write about something I learned in my MBA that struck me. One of the main advice he gives in the book is to stay away from classic mutual funds. Why is that? Most of us are too busy and don’t have time nor wish to become an investment expert. It sounds reasonable then to rely on professionals to manage our money. But should we? Learn the truth about mutual funds.

Index funds vs. Mutual funds

Let’s first briefly explain what mutual funds and index funds are.

What is a mutual fund? It’s a investment vehicle that collects funds from many investors. A money manager invests the fund’s capital by buying stocks, bonds and other assets trying to maximize returns for the investors (in theory). The underlying assumption is that it is possible to beat the market by actively trading assets in the right timing.

What is a Index fund? It’s a type of mutual fund that tracks a market index. The purpose is not to beat the market but just to replicate the performance of a market index like the S&P 500 for instance. It is way cheaper because it is simpler. There is no need to constantly buy and sell stocks and try to pick winners that will outperform the market. The underlying assumption is that we cannot beat the market so we should just track it.

Can we beat the market?

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts – Burton Malkiel, A Random Walk Down Wall Street.

The reality is that very few people can beat the market over the long period of time (20, 30 years or more). People constantly try to find ways to be the market. However a large majority of mutual fund companies actually underperform the market so it is very unlikely for an individual investor to beat the market.

When Index funds outperform mutual funds

Here is a few things you should know:

• 96% of actively managed mutual funds fail to beat the market over any extended period (and it does not include funds that were liquidated or merged with other funds due to poor track record.)
• Total fees pay by investors to mutual funds reach usually 2 to 3% per year. Vanguard 500 index which tracks the S&P index has annual fees of only 0.17%!

To illustrate what it means to pay higher fees here is the example given by Tony Robbins in his book:

There childhood friends, Jason, Matthew and Taylor, at age 35 invest $100,000 and have equal performance of 7% annually with their respective mutual funds. At age 65 they compared how much money they have. They pay respectively 1%, 2%, and 3% annual fees.

Their account balance at age 65:

Jason: $324,340

Matthew: $432,194

Taylor: $574,349

So basically, you are paying 2 or 3% annual fees to mutual funds that fail to beat the market over a long period of time when you could just invest in index funds like Vanguard that mimick the market and whose fees are much more lower. Over a long period of time it can cost you $100,000, $200,000 or more in fees depending on how much you invest! (for more information see this page: The Retirement Savings Drain: Hidden and Excessive Costs Of 401(k)s)

 Don’t try to earn more try to lose less

If it is highly improbable that you beat the market from the time you start working until you retire, how then can you increase your savings?

If you don’t try to beat the market and just track the market you are less likely to lose money since the market move upward over a long period of time.

There is four things you can do to increase your savings

1. Make sure you use the law effectively in order to pay the lowest taxes possible
2. Pay the lowest fees you can (Vanguard index funds seem to be one of the best choice)
3. Decrease your spending to save more money
4. Earn more money so that you can save more

Are you investing your money wisely? Investing is scary and people are afraid to lose their money. However, you should know that someone who invests consciously may be able to retire 10 years earlier than someone who don’t and have a comfortable income after he retire. Unfortunately, people who know most about money are generally people who already have money. People who would gain the most by knowing about investment are people in the low income bracket. I would highly encourage you to educate yourself by reading a few books about investment (see the list below). Tony Robbin’s new book is in my opinion the most practical book (especially if you live in the US) so I recommend you start with it. Just knowing a few principles can prevent you from losing a lot of money.

Few resources you might find useful

MONEY Master the Game: 7 Simple Steps to Financial Freedom
Tony Robbins application MONEY: Master The Game – 7 Simple Steps to Financial Freedom
Save More Tomorrow Plan: A plan to help you save more money at your own pace
StrongholdFinancial.com: Compare the performance between your portfolio and the recommended Stronghold portfolios (for US citizens)
Americabest401k.com: Check how your 401k is performing related to other plans
How the Economic Machine Works – Int Thirty Minutes : Video made by the billionaire Ray Dalio

Suggested readings

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel, Benjamin Graham – A classic by Warren Buffet’s professor
MONEY Master the Game: 7 Simple Steps to Financial Freedom, Tony Robbins – Practical guide to achieve financial freedom by the famous coach Tony Robbins. This book is not only about investing but also gives you an opportunity to think about the way you want to design your life based on your values. Very practical if you live in the US.
Rich Dad Poor Dad: What The Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!, Robert T. Kiyosaki
One Up On Wall Street: How To Use What You Already Know To Make Money In The Market, Peter Lynch
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Burton G. Malkiel

See also:

Myth #1 – Human Beings Need To Eat Meat

Myth #2 – I Have No Talent – Do You Need Talent To Be Successful?

 

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