Vanguard data shows index funds beat active IRA managers

 

Index funds and target-date funds are two of the easiest ways to invest in the market. Both have lower fees than a lot of actively managed funds while also being broadly diversified.

Given that, it is not surprising that a lot of investors have opted to park their cash in index funds. With an unpredictable market, a lot of investors find it easier to sleep at night with their money sitting in an index fund as opposed to trying to pick out the winning stocks from the vast universe of publicly traded companies.

Using index funds is a great option because with one simple trade you can buy hundreds of stocks, and only have to worry about the one position. The idea is simple… if the market goes up so does your portfolio. You remove the risk of having one specific stock implode and ruin your overall portfolio.

Another reason other than the reduced expense of diversification that appeals to many investors is that it simply takes less homework. You don’t have to sort through a universe of stocks to try to figure out which ones are going to trade higher and which ones are hitting a peak. You simply need to ask yourself if you believe the markets will trade higher in the long run. If your answer to that question is yes, then you can buy an index fund and just sit back and wait for the market to do its thing.

Target-date funds take this simplicity one-step further, moving from stocks to bonds as an investor ages, and also taking care of the periodic re-balancing that multi-asset portfolio requires.

These investments are great for prudent and patient investors, but some investors shy from them because they don’t offer the potential for huge paydays. You have to consider that higher risk leads to higher rewards, so you are sacrificing the potential for huge jumps in order to minimize your risk. It is up to you to decide how much risk you are willing to accept.

While investors have embraced index funds in recent years, it is somewhat surprising to hear a mutual fund manager support the use of index funds since they collect higher fees from investors who choose actively managed funds and move between funds regularly.

Vanguard, a large mutual-fund manager, recently conducted a study of investment returns between 2008 and 2012. According to its findings, self-directed IRA investors who switched money between funds often realized lower returns as a result. It found that “hands on” investors had the worst performance, and individuals who made even one single exchange over the five year period made about 1% less than investors who made no investment changes. Conversely, investors who refrained from making any adjustments to their portfolios actually outperformed Vanguard’s asset allocation benchmarks by 0.3% annually.

Vanguard says this is evidence of the so-called “loser’s game” which is the idea that the best investors are the ones who make the fewest mistakes. If you can remove the chance of making errors, you can greatly improve your rate of return.

It is easy to see this in practice. We have all gone on stretches of one winning trade after the next. You can make five or six winning trades and watch your portfolio value rise, but then you make just one bad trade that totally wipes out all of your previous gains. You have to have an extremely high win rate to achieve overall success in investing.

Vanguard’s conclusion is  that the best way to invest is to pick a low-cost investment and simply stick with it. It suggests that investors take a long hard look at their portfolios, and ask themselves one basic question… “Is there a good reason not to use a sophisticated single-fund alternative?” If you are investing for the long term, the answer to that question is no.

This strategy is not the right option for everyone. There will always be traders out there who wish to make lots of trades on their own, as they try to find the one big winner, but for the vast majority of investors it is simply not worth the stress.

Choosing a single index or target-date fund and sticking with it not only diversifies your portfolio, removes the stress of managing multiple positions, and reduces the risk of error, but as we now see also can prove to be the best strategy for solid returns.

Michael Fowlkes

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.

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