Just Buy Low Cost Index Funds

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“The less you spend on investing, the more you get to keep.”. Rick Ferri

When investors who don’t manage their costs, they pay a significant price for their inaction and inexperience. As John Bogle has famously said, “In investing, you get what you don’t pay for.” The primary issue is that investment product providers, especially annuities and actively managed funds, and financial intermediaries are selling commission-based products that take advantage of unsophisticated investors by marketing high-fee, high-commission funds that earn low returns. 

Cost Matters Hypothesis.

It costs money to try to beat the market, according to Bogle, and you pay whether or not the manager succeeds. When a group of financial people try to out perform the market, some will win and be successful, some will lose, but collectively they will get the market’s return—before fees. After fees, they will get much less. Bogle once calculated that “active stock investors lose close to 3% a year in fees, trading costs and taxes.”

“Costs matter. They matter more than past performance.” John Bogle

Occasionally, you might get lucky for a year or five or ten. Eventually, though, your luck will run out. With each passing year it becomes more likely that you will be overtaken by the law of averages.

Buffet advice to investors

Billionaire investor Warren Buffett recommends that most investors should buy low-cost index funds. In his sage opinion, buying index funds would go a long way toward solving this serious problem of overpaying for investments. Buffett’s recommends inexperienced investors and investors without time or inclination to conduct research buy index funds. His view is that index funds, such as those that mimic the S&P 500 benchmark, are a smart investment that almost anyone can follow.

“Costs really matter in investments,” Buffett says in a CNBC interview. “If returns are going to be 7 or 8 percent and you’re paying 1 percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.”

The appeal of index investments is their low cost compared to most actively managed mutual funds and ETFs. With active funds and ETFs, according to Fidelity Investment, a manager attempts to deliver performance that outpaces a chosen index, often referred to as a benchmark. Passive ETFs and mutual funds, on the other hand, try to match the performance of a benchmark.

Benchmarks may include familiar indexes such as the S&P 500, as well as custom benchmarks created by a fund’s managers. Passive investments may not offer the potential to outperform an index, but they typically offer lower costs than active funds managed against a similar index or benchmark.

When evaluating cost, most investors focus on the expense ratio—the annual percentage of assets that mutual funds and ETFs charge investors to cover services such as investment management, recordkeeping, compliance, and shareholder services. In general, these costs are much lower for passive strategies than for active ones. And, even this expense that can vary dramatically even among seemingly similar passive index funds and ETFs.

Labor Secretary Thomas Perez said during a Senate panel meeting: “The problem with our [financial] system in the U.S. is it incentivizes complexity when simplicity is all too frequently what’s called for. … It incentivizes complexity because complexity generates more fees.”

The solution and best defense against those who prey on investor ignorance, according to Rick Ferri, is investor education and requiring financial literacy in our schools and colleges. Perhaps we need to scream continuously, “Just buy low-cost index funds!” every time an investor is pitched a hyped-up mutual fund advertisement or a high-cost fund.

Investing in index mutual funds and ETFs can be an outstanding low-cost strategy. And, like any other investment strategy, investing in index funds requires that you understand what you are investing in. You need to ensure that you are investing in a low-cost product that tracks a benchmark that fits with your investing strategy.

References:

  1. https://rickferri.com/forewarned-is-forearmed-on-investment-expenses/
  2. https://www.cnbc.com/2018/01/03/why-warren-buffett-says-index-funds-are-the-best-investment.html
  3. https://www.fidelity.com/viewpoints/investing-ideas/how-to-shop-smart
  4. http://johncbogle.com/wordpress/
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