First, Let's Clarify a Few Things
Mutual funds are professionally managed investment portfolios. They are funded primarily by the shareholders (investors) like you and I. Typically, their goal is to generate the highest rate of return annually for the shareholders of the portfolio. They do this by actively trading investments inside of the fund. Marketing and advertising for new shareholders (investors) is typically done by comparing recent returns of the mutual fund to that of a benchmark--typically an index fund.
Index funds are actually a type of mutual fund. An index fund is a passively managed that seeks to match a given index. The Dow Jones or S&P 500 are two of the most common indices.
So why is there so much confusion out there about mutual funds vs. index funds?
Although index funds are technically a type of mutual fund, they differ significantly in almost every other way.
For the sake of clarity, it helps to divide the entire category of mutual funds into actively managed and passively managed. Therefore,
What's the difference between mutual funds & index funds?
Fees and management style.
The typical fees of a mutual fund are in excess of 2%. The typical fees of an index fund are often less than 0.1%. Doesn't sound like much? Well, it is!
Let's look at an example headline from our friends over at NerdWallet:
Millennials have decades to save for retirement, but also decades of exposure to avoidable investment fees. NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
What is even worse is that this only looked at a 1% fee. Compounded over time, the loss of that measly 1% fee is extraordinary as outlined above. Remember, the average active mutual fund fee is well over 2%.
To make matters worse, if you happen to hold an actively managed mutual fund in a taxable brokerage account, you would need to beat the passive fund by 4.3% just to match the return of the passive fund. Why 4.3%? Professor Mark Kritzman of M.I.T. conducted a study reported in The New York Times.
So if your so-called "index beating" mutual fund was held in an taxable brokerage account.
If you held this actively managed fund in a tax-advantaged retirement account, you would still need to generate at least 2% higher returns just to break even with the passive index fund.
The average actively managed mutual fund consists of the following fees:
Why choosing actively managed mutual funds is a mistake...
There are professional money managers who spend their whole entire life's work trying to time the market and, guess what... 92% of actively managed funds fail to match the returns of the market (i.e. S&P 500 index) over a 15 year period.
If your investment horizon is 15 years or greater- which includes you unless you plan on dying in the next 15 years- you stand practically no chance of picking the 8% of actively managed funds that will outperform the market. What's worse is that not only would the actively managed fund you chose have to beat the market, but it would need to beat it by at least 1.5 to 2.0%.
Why would it need to beat it by at least 1.5%? Fees and expenses. The average index fund has less than 0.1% in fees compared to the 2 plus percent fees of active funds.
See why you are better off choosing index funds instead.
I know many are thinking that 1 or 2% in fees doesn't sound like a lot, but trust me, it is. For example, saving even just 1% on fees could result in big differences compounded over time. Remember, the cost of a 1% fee could cost you $590,000 over 40 years, which is a very typical investment horizon.
WARNING: Your Financial Advisor Will Sound Very Convincing!
Remember, index funds---i.e. passively managed funds---do not generate revenue for your advisor's company. The index funds simply don't make money for your advisor because they do not have all of the above fees associated with them. Beware, your advisor might still charge an "advisor fee" or an "administration fee" which is why I am a firm believer in the DIY method of investing in index funds.
I promise that your current advisor will pitch you something like this:
Our advisement provides you expertly managed portfolios with industry leading research tools that often outperform index funds. We have an experienced staff dedicated to selecting blue chip funds that have demonstrated superior returns in recent market conditions.
This is literally what my advisor emailed me when I exited a high-cost fund through a previous employer's 401(k) program.
It's bullshit. Complete nonsense. Even if they do generate higher returns, it does not last. Never has. Likely never will.
I am certain you will be able to find funds that outperform the market over 1-, 3-, or even 5-year periods. But outperforming index funds over your entire investment lifetime? Outperform for 30 or more years, in a row? They don't exist. Not one ever has.
Perhaps some of you are in a position to require a financial advisor. Some might need to receive tax advice. There are even some of you who are not willing to take just a few minutes to open your own account or call your advisor and inquire about fees and how to lower them by switching to passively managed index funds in your portfolio.
To those of you which this applies, I encourage you to seek the professional help that you require. Do not do so blindly however. Ask. Ask. Ask.
Ask about fees. Ask about expenses. Ask about commissions. Be inquisitive. It's your money and to them, it's just a job, so ask them about the costs associated with their account.
Your failure to ask could result in hundreds of thousands of dollars of expenses over a lifetime.
It's not unreasonable to think that if you start investing in your twenty's, and you live to be 90, you may be invested in the market for 70 years! Now imaging what those 2% fees will do to you compounded over 70 years.
Be smart. Be curious. Don't be shy and don't be afraid to ask some questions. Even if you were able to save 1% in fees just by switching to passively managed funds, it could result in you retiring much earlier with a lot more money someday. It's worth it.
Until next time...
Comment below with your experiences with active vs. passive funds. Index funds vs. mutual funds. Fees and expenses. Run-ins with your advisors commissions. Share with your community.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” - Albert Einstein
How dramatic is the effect of compounding?
For finances, and nearly anything else, the value of compounding grows exponentially logarithmically, not in linear fashion.
This means that as you move along the horizontal (x) axis, the growth on the vertical (y) axis grows exponentially.
Frequently, in the personal finance community, we value money on the horizontal (x) axis, and net worth or money on the vertical (y) axis as follows:
After 10 years, your initial $10,000 (assuming you added nothing else), grows to only $19,990. Not bad, but this will not get you rich.
After 20 years, your initial $10,000 (again assuming you add nothing), grows to $43, 157. Again, not too bad considering you never added another dime - which is typically very unrealistic for those interested in saving and investing.
Fast forward to the 50 years mark, your initial $10,000 investment turned into a whopping $434,274. Again, this does not adjust for inflation and just shows you what your initial dollar amount will potentially turn into after 50 years of passive index fund investing.
The Power of Saving PLUS Compound Interest
You may feel somewhat underwhelmed after that first example. That is fine. The power of compounding is quite dramatic, however some folks argue and become upset when they hear about 50 plus years of investing. It might just be too far out for most people to imagine and remain motivated on the path to F.I.
This is where demonstrating the power of saving plus compound interest comes into play.
Take our initial investment of $10,000, use the same parameters of hypothetical growth at 8% compounded annually, and add $500 a year.
This time it only takes 43 years to cross the $400,000 mark. At the end of 50 years, your initial investment of $10,000 plus an additional $500/yr, compounded at 8% annually, turns into $720,000.
Now what if you simply take your initial investment of $10,000, and add $5,000 per year to an IRA, compounded annually at 8%. Essentially this would be nearly maxing out an IRA every year ($6,000 contribution limit as of 2020).
Following this process of $10,000 initial investment, plus $5,000 contribution annually to an IRA, compounded at a hypothetical rate of 8% annually - you would be a millionaire in 36 years with your investments growing to $1,078,364.
At the 50 year mark, you'd have potentially $3.3 million in the bank. Not too shabby.
So what does this all mean...
As you can see, compound interest takes time to reveal its' magic. The earlier you start, the longer you have for compound interest to work in dramatic fashion.
Consider the rule of 72. Take your annual interest rate (in our example 8), and divide 72 by your rate. This will tell you how many years it takes your money to double.
In our example, 72/8 = 10.3 years. In other words, every 10 years our money would double.
How do I make compounding more powerful?
As you can see, each of our models demonstrates - after a hypothetical return - a "hockey stick" growth curve. This means your money compounds and grows exponentially upward instead of a straight line.
Of course, this does not happen consistently. The stock market returns look nothing like a smooth line the way our model shows.
The market is actually quite volatile. It takes hard dives and high climbs based on investor behavior, consumer sentiment, inflation, pricing, GDP, etc. Many factors determine market returns.
Most estimates, in the 200 plus year history of the stock market, reveal returns in the 8-10% range. Remember, this is just an average. Do not expect these returns on a reliable and consistent basis. Some years will be higher, and some years will be much, much lower.
However, unless you are assuming that America will "go out of business", there is a potential way to improve the power of compounding.
The concept is quite simple...
START WITH A HIGHER INITIAL INVESTMENT.
To illustrate my point, say you start with an initial investment of $100,000, instead of $10,000. Do not add another dime to that $100,000. Ever.
In 50 years, after an 8% return compounded annually, you'd see your initial investment grow to...
This is approximately $1.4 million more than what you would have compared to if you initially invested $10,000 plus $5,000 a year compounded at 8%.
To illustrate this point further, in the model representing a $10,000 initial investment plus $5,000 annually, you will have contributed a total of $260,000 of capital with a final worth of $3.3 million.
By starting with a greater initial investment, not only will you be worth $1.4 million more - at a total of $4.7 million - but you will contribute $160,000 less of your own capital.
The power of compound interest is one of the primary motivators that keeps me steady on the path to F.I.
Consider visiting a compound interest calculator and plugging in your own numbers.
Remember, our models and examples are completely hypothetical and do not represent real returns, nor are they adjusted for inflation. In no way is this a guarantee of returns. Please seek guidance from a financial professional, of which I am not.
Still, the point remains. The dramatic effects of compound interest are on display.
The most optimal recipe would be to start big and start young. Nevertheless, conventional wisdom and investors agree that although investing as young as possible is key, the next best time would be to start ASAP.
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Further, take a look at our favorite resources that built the foundation for our awareness of financial independence, frugality, and investing.
Before we begin, this is absolutely not investment advice and I am certainly not a financial professional. Please understand this is entirely for informational purposes only and in no way are we making any claims about this style of investing. Use your head people, this is a blog, not a financial consultation.
So you want to be an investor?
First, you need to attain a savings rate. Without a savings rate, or positive margin above spending, you will lack the most sufficient tool required for investing, spare change.
Yes, I know many of you will protest and say but you could use OPM (other people's money) or perform marginal trading, etc.
For those of you that might say that, please do not continue reading the blog. We are not firm believers in gut-wrenching borrowing on margins or owing money to anyone. We are the type that pays off the full credit card bill - or at least the full statement balance - every month! That's what brings us security.
Deciding where to save it
Once you've broken free from spending every single dollar you earn, you have some choices.
Where do you want to put all these newfound savings (hopefully they need a dumptruck to transport it)...
Here are some of the primary investment vehicles where you can save your money and have access to investing in "the market" (not supposed to be an exhaustive list, just the most common):
I just happen to use Fidelity and Vanguard because I have found they offer the lowest account fees and best customer support around. I have tried MANY other investment companies for various accounts without much success. They will remain nameless.
To open an account in order to begin investing, just visit the company site or call the company directly, and seek advisement for how to open any of the following accounts - or even ask about one's I haven't listed such as a 457 plan, etc.
I do not use a financial professional and choose to pick the funds myself. I do this for the lowest possible cost and the greatest potential return. Read the two books below if you think that you cannot do it yourself when it comes to investing.
How to invest it once you've saved it...
The simplest way is low cost index funds.
If you need more confidence in investing in index funds but are concerned about stock volatility, here are two must-read books for you:
How do you do it?
Sometimes it depends on what platform you are using.
From looking around the community, if you choose Vanguard, folk's love their VTSAX (Vanguard Total Stock Market Index Fund) fund as an example of a low cost index fund that tracks the total returns of the stock market.
For those Fidelity users, FXAIX seeks to match the performance of the S&P 500.
In the end, it does not matter what platform you use. I primarily use Fidelity and Vanguard due to the low cost nature of their funds, and their accounts.
When considering index fund investing, here is primarily what you are looking for:
Leave us a comment based on what you learned from this article. Please let us know what you would like us to post on in the future.
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Dr. Jon is a physical therapist by day, and a dedicated frugalist by night, deeply enthralled in the thrill of "pinching pennies" and investing the margin.