The Little Book of Common Sense Investing provides a detailed overview of two different investment options: actively managed funds and index funds. These blinks explain why it's better to your money in a low-cost index fund instead of making risky, high-cost investments in wheeling-and-dealing mutual funds.
Have you ever invested in the stock market? If so, you might have realized that evaluating the attractiveness of a stock is tricky business.
That’s why many investors choose not to invest directly into stocks, but instead put their money in an actively managed fund. Here money is pooled from several investors and then invested into stocks by a specialized fund manager, who regularly evaluates and revises the stock portfolio according to the current situation.
Unfortunately, that kind of investment is risky.
Because the costs of investing in such a fund are very high. As an investor, you’d pay the brokerage commissions, the fund manager’s fees and so forth. All those fees add up to a hefty chunk of your expected profits.
If the funds perform extremely well, you might not mind those costs, but in the long run, actively managed funds are likely to yield you less profit than the overall stock market.
How can that be?
For one, speculating on stock prices is simply not a sustainable strategy. You might think that a fund can generate huge profits by, for example, buying stocks when they are undervalued and selling them later when they reach their true higher value, but in the long run this strategy can’t produce more earnings than what the underlying companies are earning, which is reflected in the overall development of the stock market.
Add that pitfall to the high costs of the funds, and the result is that an actively managed fund will generate significantly less profit for you than a passive, low-cost index fund that merely mimics the performance of the overall market. In fact, if you had invested $10,000 in 1980, by 2005 you would walk away with 70 percent less if you invested in an active fund rather than an index fund, due to fees alone!