By Paul A. Merriman
Timing the market is a recipe for failure. Do this instead.
One of the most common complaints we hear from investors is, “I don’t feel like I’m getting the returns I should be getting.”
And when we dig into this issue one-on-one with people, we usually find one of two reasons, or both.
First, many investors have no realistic idea of ​​what to expect from their portfolios — they just want more. Second, investors all too often entrust their portfolios to people (and companies) who essentially charge a high price for making bets with their money.
We’ll come back to the first point later, but for now we’ll focus on the second.
The culprit is active management, which is based on the idea that educated, knowledgeable and hard-working people can beat the market by choosing which stocks to invest in and deciding when to buy and sell.
It sounds like common sense, but it rarely works in real life.
Many people want to invest in “the next Microsoft (MSFT),” but living up to that expectation is one of the biggest mistakes you can make.
In 1986, there were tens of thousands of publicly traded companies you could buy stock in. One of them was Microsoft, a tiny company run by a nerd who dropped out of Harvard and spoke in a jargon that most people didn’t understand.
Looking back, do you wish you had put all your money into this little company? Do you wish you had had the opportunity now to be part of an early stage company that will be hugely successful 10, 20, 30 years from now?
If so, you could be a victim of one of Wall Street’s most lucrative niches: active management.
Hundreds of mutual funds and thousands of managers are eager to take your money in the hope (and that’s all, really) of generating big profits.
There’s a better option: low-cost index funds that aim to capture the market’s returns.
If you choose active management instead, it could end up costing you much more than you anticipated.
Read: Forget about your retirement portfolio beating inflation over the next decade
You lose as soon as you start
Actively managed funds are sold, not bought. Most investors learn about actively managed funds from financial professionals who earn a commission in some way from selling the funds. Often, investors pay an upfront sales charge of 5.75%, but not always.
You may think you have $10,000 invested, but in reality, sales charges cause you to lose $575 on the first day you own the fund, and you only actually invested $9,425 in the fund.
Only after earning the 6.1% return will the value of your account return to the original $10,000.
In most cases, you can buy index funds without paying any commission.
My rule of thumb is that a 0.5% difference in returns would likely cause an investor to lose $1 million over their lifetime.
A $575 sales charge means that, every year that you own the fund, you will earn 0.575% less than you would have if you had invested $10,000 in the same assets contained in the fund itself — in other words, if you hadn’t paid that fee.
Pay more every day
Most people I talk to seem to be money conscious, and they’re unlikely to be willing to shell out $1,000 for something they can get cheaper and more easily elsewhere.
But every day, investors in actively managed funds pay unnecessarily high costs: These funds have operating expenses at least 0.5% higher than index funds, which means lower returns. At the very least, they lose an additional $1 million.
Taxes may be higher
If you invest in a taxable account (not a 401(k) or IRA), you are taxed annually on any dividends or capital gains you earn in the fund, whether or not you take those earnings in cash. You can think of this as a tax liability.
The tax burden on the Vanguard 500 index fund is 0.34%, according to Morningstar. The comparable figure for the average actively managed fund is 1.49%.
Another $2 million disappeared.
Your fund may underperform
Of course, the reason you hire an active manager is to get the services of a person (or team) who is good at picking stocks and knowing when to buy and sell.
In most cases, it doesn’t work.
S&P Dow Jones Indices publishes a comparison of actively managed funds’ performance against their benchmarks twice a year.
There are three main conclusions from the 2023 year-end report:
Most actively managed funds have consistently underperformed their benchmark indexes, and this trend has been consistent for over 20 years. Over time, the percentage of actively managed funds that underperform their benchmarks typically increases. Active funds that outperform their benchmarks rarely sustain that performance over subsequent periods.
Specifically, as of the end of 2023, about 85% of all domestic investment trusts had underperformed their benchmarks over a five-year period. The failure rate rose to 91.4% over a 10-year period and 94% over a 20-year period.
Only one of the four large-cap core funds returned at least 9.47% over the 20-year period, compared with the S&P 500’s return of 9.69% over that period.
Success doesn’t last
Some active managers have impressive track records: a familiar case to investors in the 1990s is that of Bill Miller, whose Legg Mason Value Trust fund beat the market for 15 consecutive years, gradually raking in billions of dollars from investors eager to get in on the money-making action.
Then a funny thing happened (but it’s no surprise to academics): Over the next decade, Legg Mason Value Trust ranked in the bottom 1% of all funds.
Of the 804 large-cap stock funds in existence at the end of 2003, about 70% had disappeared by the end of last year, according to a report by Dow Jones Indices. If those funds had performed better, they would likely have survived.
You will be disillusioned
At some point, you may realize that you’re not getting the returns you expected, and if you’re relying on a salesperson for advice, they may suggest a different actively managed fund.
A pattern of hope followed by disappointment will likely see you back in the same place, probably paying another 5.75% sales fee.
Or you could simply sell the funds and hold onto them in cash until you know what to do next, which is a recipe for trouble.
Every study of investor behavior points to the same conclusion: long-term investment results are best achieved by staying the course, not by trying to time the market.
I mentioned at the beginning of this article that most investors don’t have a realistic idea of ​​what they should expect from their portfolio. To me, the answer is pretty obvious.
Over time, you can expect the equity portion of your portfolio to perform in line with the asset classes you invest in. Historically, that’s about 10% if you’re focused on a large-cap mix like the S&P 500 SPX. If you diversify beyond that index, you can expect to outperform somewhat, though not every year.
Very few actively managed funds can deliver such returns: Sales charges, management expenses, transaction costs, poor timing decisions, poor stock selection and taxes can all combine to eat into returns of 3% to 5% per year.
That’s the bad news. The good news is that it’s easy to build a portfolio of low-cost index funds that fit your needs and risk tolerance, as I explained in detail in my recent article here.
For more on this topic, check out the most popular podcast I’ve ever recorded: “Is This the Best Reason to Use Index Funds?”
Richard Bach contributed to this article.
Paul Merriman and Richard Bach are the authors of “We’re Talking Millions! 12 Easy Ways to Live Better in Retirement.”
-Paul A. Merriman
This content was produced by MarketWatch, an operation of Dow Jones & Co. MarketWatch is published independently of Dow Jones Newswires and The Wall Street Journal.
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07-06-24 1151ET
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