Henry Blodget is a former Merrill broker and one of the sleaziest market players in history. Yet he later wrote a very useful book on investing. He has a recommendation on avoiding getting rooked.
Use index funds.
And for most people, according to investors and managers as varied as Warren Buffett and Peter Lynch, index funds are the best way to amass wealth for someone who is committed to a long-term investment plan. An index fund is a passively managed investment. Instead of constantly buying and selling securities in an actively managed fund, index funds fill out a portfolio, such as the stocks of the S&P 500, usually just one time a year.
Which wins? Active or managed funds?
Four Out of Five Mangers Lose
In most years, only 20 percent of actively managed funds will outperform index funds. And usually those 20 percent star performers one year will not be the star performers in the next year. It is very rare to find a manager who beats indexes most years.
Sure, once in a while a manager comes along who consistently beats the average over the long term and justifies higher costs. But this kind of manager is usually very difficult to find. And, when you do, he or she is often past the peak performance or you have to pay a fortune to obtain his or her services.
So one often ends up overpaying when one seeks out the latest investment superstar. You are paying for past, not necessarily, future successes. Most of the time, the star manager, charging premium costs, disappoints.
And lower costs are why the high-priced funds so often lose to the plain vanilla funds. In the final analysis, writes John Bogle, it is not alchemy, but cost efficiency that drives the index advantage. [See “The Triumph of Indexing,” p12, by John Bogle. This is just one of Bogle’s many good books for the individual investor. I would also recommend Bogle’s “Commonsense on Mutual Funds.”].
Wayne Wagner, in his book, offers readers a secret. Anyone can become a millionaire.
How?
Wayne Wagner’s Lunch Recommendations
Start early. Pack a lunch.
“Take a few hundred dollars a month, possibly the amount you spend on 30 lunches a month, and invest your money every month in a good index fund. That’s it!” [From “Millionaire. The best explanation of how an index fund can turn your lunch money into a fortune.” Wayne Wagner and Al Winnikoff, p33 (Renaissance Books, Los Angeles, 2001)]
Wagner offers numerous examples of how it works, but let’s just take one. Say you put $300 a month into an index fund. That’s about 75 dollars a week or a little under eleven dollars a day. You earn nine percent a year, about an average rate of return for the stock market, and invest for 30 years. You have $553,000.
But say you do it for ten more years, 40 years. Then you have $1.414 million. Those extra ten years on top of the 30 years were stupendous. That’s why Wagner, and almost every other sensible investment advisor, emphasizes “start early.”
By the way, these wonderful numbers don’t include investment taxes. But, as we show below, your investments will take less of a hit from the taxing Potomac Poloniuses if you’re in an index fund as opposed to a managed mutual fund, where every trade—and managed funds trade a lot—can trigger a tax bill.
Less Is Better
Part of why most people tend to do better in an index fund over the long term than in a managed fund is the cost advantage. That’s because you’re too smart (stingy?) to give the tax man and the fat securities industry more than they usually get.
Let’s compare the two. The average actively managed domestic equity fund, which trades a lot by buying and selling securities throughout the year, has a yearly expense ratio of about 1.4 percent. Buying and selling always requires expenses that are passed on to the investor. The higher the expense ratio, the more it hurts the fund’s performance. The lower the expense ratio, the better the fund can perform.
However, the average domestic equity index fund, which usually just changes a portfolio once a year based on an index it is trying to duplicate, is about 0.2 percent. And, in some cases, it can be as little as 0.1 percent. One caveat: Any so-called index funds that are not dirt cheap, which don’t have expense ratios of around 0.2 percent or less, are trying to pull a fast one on the investor by invoking the good name of index funds, but offering something else.
The average index fund investor who refuses to overpay begins the year with at least 1.3 percent or 1.4 percent cost advantage over the investor who is paying for an actively managed fund.
The mistake one makes by buying an average-cost mutual fund is that the average cost is “mind bogglingly” expensive, Blodget writes. [The Wall Street Self-Defense Manual,” p4].
Blodget should know. He often palmed off his company’s pricey funds on clients when index funds were better performers.
The mistake can cost an average of as much as two percent a year in returns. For example, Vanguard, surveying the returns of a Vanguard S&P 500 Portfolio index fund against the average domestic equity fund over the long term found the index fund won easily. The index returned 14 percent a year compared to 12.2 percent against the average domestic equity fund that was more expensive. The difference was 1.8 percent.
But it was worse than that. The study didn’t include the managed funds’ sales charges. Any reputable index fund has no sales charges, which are fees you pay to enter or leave a fund as well as higher investment taxes. So I think it is fair to say that the difference between the cheap as you know what index fund and the high-priced fund, the managed domestic equity fund that runs up big bills, is at least two percent a year over the long term.
Two Percent Can Equal a Fortune
Now some skeptical readers may be asking: Who cares? Isn’t two percent a year an insignificant amount?
Over the short term, the answer is yes (Although if anyone wants to send me two percent of their savings from using index funds for a year, then please do. I have lots of bills and taxes to pay living here in the Peoples’ Republic of New York). However, a two percent difference over the long term, 10, 20 or 30 years, is an incredible amount. It can be an amount that can make dreams come true or it means disappointment because one didn’t accumulate enough. Let’s look at an example.
Bob Spend Big puts $300 a month into his managed funds. He uses pricey funds with high expense ratios. He earns seven percent a year. After 20 years, he has some $157,000. And after 30 years, he has $368,000. That sounds good, right? Actually, it’s lousy compared to what he might have done had he shopped for funds a little more carefully.
John Don‘t Waste Money also puts $300 a month into his funds, but they are low priced index funds. He earns not seven percent, but nine percent a year. After twenty years, he has $201,000. And after thirty years, he has $553,000, some $185,000 more than Bob. After 40 years, the disparity is even greater, Bob has $1.414 million compared to John‘s $792,000.
John, after forty years of investing and refusing to waste money, has some $622,000 more than Bob, who overpaid for his funds. By the way, Bob ends up farther ahead than that because we are not figuring in the taxes.
Index funds tend to incur less in investment taxes because they trade less than managed funds, which are buying and selling stocks frequently. And each time one sells an asset, one can run up a tax bill that the fund company passes on to the investor along with its management funds and only God knows what else costs passed on to the unsuspecting investor.
Here’s an example: I used to go to a lot of luncheon/dinner events staged by mutual fund companies. Sometimes there would-be entertainment along with free bags of various goodies as part of the let’s take care of the press approach. One firm once offered me a World Series ticket “at face value” for the sixth game of the 1996 World Series. I declined. I watched it en casa. My beloved Yankees closed out the Braves and won the series. I often thought, who was paying for this care and feeding of the press? Can you guess?
By the way, I once went to an event for the launching of a John Bogle book. They didn’t offer me a cup of coffee. When I asked for some water, a person informed me that there was a water fountain down the hall.
Index funds avoid so many expenses and Bob understood this. And, because he was frugal, and because he invested month after month in good times and bad, ended up with a lot more than John. So, for those who say two percent doesn’t matter, I ask: Would you rather be Bob or John?
Do You Want to Keep Riding the E-Train in Your 60s?
The answer to that question may seem unimportant right now. But some day, when you’re in your 50s or 60s or just sick of work in general or of a certain job with an obnoxious jefe, and you desperately want to achieve financial independence, the answer to that question might be the difference between a happy and an unhappy rest of your life.
This is not exaggeration. I know several people in their 60s who continue to work almost every day and go into Manhattan on the wretched New York City subways. By the way, the word wretched is not an exaggeration even though then New York Governor Andrew Cuomo once said New Yorkers should be “proud” of their subways.
I don’t know anyone who “proudly” and happily rides the subways on a regular basis. However, like almost every elected official in New York, Cuomo rarely if ever rides them. (The proud comment reminds me of the famous Arthur Godfrey line: “I’m proud to pay taxes in the United States but I’d be just as proud to pay half as much”).
Why is it so important to be among the Bobs and not the Johns?
Johns don’t have enough in savings and must continue to earn a living. Maybe their primary income is from Social Security, which doesn’t provide an adequate retirement income unless it is supplemented by large private income.
By the way, I go into Manhattan from time to time on those same egregious trains. These days I do it infrequently. And, gracias a Dios, I rarely have to go into the city or work at a full-time job or any job if it doesn’t please me. That because many years ago I stopped living paycheck to paycheck. That’s something I once had to do for many years. When people speak fondly of “the good days,” those are not the days I think were great.
Now that we have a plan to accumulate a large amount of assets over the long term, significant assets that can greatly improve the quality of your life, it’s time to stop and think about something that can ruin that plan. It is the problem of getting dazzled by the latest fashion in investing. It is the problem of choosing the short term over the long term. It is a mistake that many investors make who are looking for a short cut to immediate financial independence
We’ll discuss this potential threat in our next chapter.
