HapiMoney

Here’s my first post on investments to buy that aren’t cash or short term cash equivalents. Read up, it’s important.

Index Funds are like a mutual fund, but they are set up to mimic indices like the S&P 500 or Wilshire 5000, etc. Here’ s the definition courtesy of Investopedia:

A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

It’s so easy that even a caveperson could do this. Seriously, all you have to do is figure out what the S&P 500 index (or similar index) is comprised of, and then buy those exact same stocks in exactly the same proportions.

So why is this different than an actively managed mutual fund (a mutual fund being defined as a professionally managed portfolio of stocks). After all, these mutual funds pay very smart people with decades of experience millions of dollars to try to pick stocks – you would expect a big return.

Firstly, Index Funds cost very very little to maintain – you basically replace the million dollar stock picker with a monkey who pushes  buttons once a quarter and demands ample banana supplies. According to the Motley Fool, Actively Managed fees run on average 1.6% per year – meaning that if the mutual fund’s portfolio returns 10%, they give you about 8.4% back – a 20% kick to the shorts. Index Fund fees are a fraction of that, often about one tenth of a similar mutual fund.

Secondly, in aggregate, mutual fund managers suck at picking stocks. Thats not to say that some of them don’t have good years, and it doesn’t even mean that one or two of these guys can’t have a run of several good years in picking. However, on average, managers UNDERPERFORM the market, especially after you take fees into account. And the managers who do perform well one year aren’t likely to repeat this performance in the future. From Wikipedia:

Certain empirical evidence seems to illustrate that mutual funds do not beat the market and actively managed mutual funds under-perform other broad-based portfolios with similar characteristics. One study found that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992.^[9] Moreover, funds that performed well in the past are not able to beat the market again in the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman, 1989).^[10]

In summary, just say no to expensive mutual funds and start investing in a diversified index fund.