Monday, May 5, 2008

Passive Funds

I ran into a couple old articles on that are interesting. They have to do with how bad of investment choices people make. My current view is that picking stocks is a suckers game, but investing in the stock market is the easiest money you can make. I am therefore pretty convinced that the only intelligent investment is an index fund. These articles encourage my viewpoint.

"But the bigger issue is that active money management—aka stock-picking, the strategy employed by most funds—doesn't usually work. According to study after study, the vast majority of fund managers can't generate enough extra performance from active trading to offset the costs of their efforts (costs that include salaries, bonuses, and fund company profits). This problematic finding doesn't stop fund companies from selling active-management prowess, of course—or from collecting huge active-management fees even when performance stinks. Your odds of picking a market-beating fund are somewhere between one in six and one in 30 (roulette-like); the fund industry's chance of collecting big fees, meanwhile, is 100 percent.

If alternatives didn't exist, active managers could just hide behind the rhetoric about offering small investors a simple way to pool resources and diversify, etc. Alas, alternatives do exist. Passive funds buy all the stocks that meet given criteria and leave stock-picking to folks who hope that they can defy the odds (and to their customers). Because passive management costs less than active management—fewer expensive MBAs, lower trading costs, lower research costs, lower taxes—passive funds generally do better than active funds: What they lose in performance (surprisingly little), they more than make up in costs."

"past performance is nearly worthless as a predictor of future results. Any firm that argues, therefore, even indirectly, that a mutual fund will do well because it has done well is taking advantage of your natural tendency to be too impressed by the past."

"Over the last 20 years, the stock market has averaged a 12 percent annual return. But according to a study by Dalbar Financial, individual mutual fund investors earned only about 4 percent. A survey by Vanguard finds participants in its 401(k) plans earn only about one-half the average—6 percent a year. It is almost impossible to believe, and unpleasant to contemplate, but practically all individual investors are below average."

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