Mutual Funds vs. Index Funds

Which is the best way to Invest in the Stock Market?

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What is the best way to invest in the stock market, through actively managed Mutual Funds or passively managed Index Funds?

Before we get to that let me begin with a question some of you might be thinking.

What about Picking Individual Stocks?

First, if you are filthy rich and have some money you don’t mind losing and want to take up stock picking as a hobby, by all means do it.

For the rest of us, I’ll explain why becoming a “stock picker” is a bad idea by using Facebook as an example.

This time last year, Facebook was one of the hottest stocks on the market and along with a few other tech giants, was responsible for much of the 2017 gains in the S&P 500.

If you invested in Facebook stock one year ago, you would be looking like a genius, at least for the first 7 months of 2018. Between December 4th and July 25th Facebook stock increased by 27%. Facebook and technology stocks, in general, looked completely unstoppable.

Since July 25th Facebook stock has dropped by 36%. The company can’t seem to go more than a week without a new scandal making headlines. All those individual stock pickers who started investing in Facebook last July because it was “a hot stock” are feeling some serious pain right now.

I am sure you have heard the phrase, “don’t put all your eggs in one basket”. Investing all your money on Facebook is the same as putting all of your eggs in one basket and then handing your basket over to Mark Zuckerberg.

Diversification is important because we have no idea what the future holds and no ability to influence future events. Investments that appear to be flying high can quickly plummet and look more like the Titanic. Unless you have a crystal ball, you can’t be sure which investments will take off and which investments will sink.

Going back to the Facebook example, by the end of 2019 it could reach new all-time highs or new all-time lows. I have no idea which way it will go. That is why I stay away from picking any individual stocks.

Mutual Funds and Index funds share one important feature that makes them a better choice than picking stocks for long-term investors — diversification.

Diversification

There are three general forms of diversification that investors should consider to manage risk.

1. Diversification Within an Asset Class
Using the Facebook example, rather than investing all your money in a single stock (Facebook), you could spread your money throughout a number of stocks, mutual funds or Index Funds.

Why would you invest in a single company in the stock market when you could invest in every company in the stock market? In the wolds of Vanguard founder, Jack Bogle;

“Don’t look for the needle in the haystack. Just buy the haystack!”

2. Diversification Across Asset Classes
No matter how many stocks you spread your money across there is always the possibility that the entire stock market will decrease in value. To help manage that risk, most investors also put some of their money in different assets such as bonds and real estate.

3. Diversification Across Countries
To diversify your investments even further, you can invest globally. Rather than holding only U.S stocks and bonds, why not consider allocating some of your portfolio to international stocks and bonds?

If there is a recession in the U.S but not a global recession, your international investments might have positive returns in years your U.S investments have negative returns.

How are Mutual Funds and Index Funds Similar?

At their core, Mutual Funds and Index Funds are a pool of money collected from individual investors, which is then invested in stocks, bonds, and other income-producing assets.

Individual investors can purchase shares of Mutual Funds and Index Funds in the same way you might purchase the share of an individual stock. In the same way, you are purchasing a small piece of ownership of Amazon when you buy an Amazon stock; when you buy a share of a fund, you are purchasing a small piece of ownership in the fund company.

The value of that share is determined by the number of shares issued and the total net value of the assets held within the fund.

Both Mutual Funds and Index Funds Provide Diversification

This is especially true for those of us who don’t have hundreds of thousands of dollars to invest.

Let's say you have $100 and you wanted to start investing in a diversified portfolio of say 70% stocks and 30% bonds. How far would that $100 get you if you were investing in individual stocks and bonds?

Nowhere.

When you consider the stock price for one share in Amazon (at the time I wrote this) is $1,570 you can see that it’s very difficult for a small investor to spread their money around. If you had $100 per month to invest, you would need to save up for 16 months before you could buy a single share in a single company.

That is where Mutual Funds and Index Funds come into play. That same $100 might get you several shares in a fund. That fund may have stock holdings which include Amazon, Apple, Netflix and all of the other blue-chip companies (including the non-sexy stocks that could be more profitable).

You can also invest in Mutual Funds and Index Funds that diversify across asset classes by including bonds. But for tie remainder of this discussion, I’ll focus on equity funds.

How are Mutual Funds and Index Funds Different?

The major difference between Mutual funds and Index Funds is that Mutual Funds are actively managed while Index Funds are passively managed. As a result of this difference, Index funds also have much lower management expenses which in my opinion elevate Index Funds over Mutual Funds.

Active vs. Passive Management

Traditional Mutual Funds are actively managed, meaning the fund manager is picking individual stocks and investments. Whereas Index Funds are passively managed, meaning the fund manager is only buying stocks to match the composition of the index they are tracking.

Active Management

An active manager of a traditional Mutual Fund will try and pick which stocks he or she thinks will outperform the market. We already outlined why it’s a bad idea for you to pick individual stocks and the same logic applies to fund managers.

Fund managers are extremely intelligent people with vast resources at their disposal, including a team of highly intelligent researchers working for them. But at the end of the day, they are still people. They don’t have a crystal ball and they cannot see the future.

They can model the future, but after six years acquiring two degrees in economics, I can tell you that even the best models fail to predict the future with precision.

Don’t get me wrong, these fund managers will do a better job at picking stocks than you will (no offense), but study after study shows that actively managed funds fail to beat the average return of the stock market.

Passive Management

Those of us who know enough to know we know nothing, embrace passively managed, Index Funds. Since we know we cannot beat the market, we are happy to take the average return of the market at the lowest possible price.

One of the most popular forms of Index Funds is S&P 500 Index Funds. The S&P 500 is an index made up of the 500 largest stocks on the U.S stock market. This represents the majority of the U.S stock market.

An S&P 500 Index Fund aims to mirror the returns of the S&P 500. It does this by investing in the 500 stocks that comprise the S&P 500 Index, in proportion to each stock’s relative share of the Index.

For example, if Amazon made up 3% of the S&P 500 Index than 3% of the assets of the S&P 500 Index Fund would be comprised of Amazon shares.

Index Funds do not need to employ a team of highly paid researchers and other support staff. As a result, the management fee you pay for an Index Fund is significantly less.

Those fees add up over a lifetime. I wrote here, about how a 1% management fee of a Mutual Fund compared to a 0.1% management fee of an Index Fund could cost you nearly 30% of your retirement savings over a 40 year period.

That analysis may be underselling the true impact, considering you can invest in Vanguard S&P 500 Index Fund for 0.04% per year and many actively managed funds often cost between 1%-2% per year in management fees.

The Winner

In my opinion Index Funds are the clear winner over actively managed funds for two reasons;

  1. Over the long run, they are likely to have better returns.
  2. You will save lots of money in management fees.

The result is you will have more money in your pocket when you are ready to retire.

Of course, you should do your own research and come up with your own conclusion before investing your money. I would encourage you to do the research and then let me know if you come to the same conclusions.

For an expanded Discussion on Passive vs Active Management Check out this Video

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.