Devoted to understanding the basics and fundamentals of investing

I've spent the last couple of weeks writing about investing basics.  It is necessary to get everyone on the same page.  I want to spend some time talking about how investors might invest.  It should be more fun.

I was at church last night and a friend asked me about an article in the Sunday Wall Street Journal.  The title of the article is, "Fund Indexers, Take (Another) Bow" and it is written by Jonathan Clements, a columnist who writes "Getting Going."

Jonathon talks about one of the great secrets of investing.  The secret is that IT IS VERY HARD TO BEAT AN INDEX FUND OVER LONG PERIODS OF TIME.  Most brokers want you to buy an actively managed fund.  They, and the fund get paid more for active managed funds.  An inexpensive index fund like the Vanguard 500 might have total expenses of 1/2% and some are much lower.  An actively managed fund including transaction fees might run you more than 2% per year.  That difference in expense makes it very hard to beat an index fund. Let me give you some of the statistics Mr. Clements cites in his article.  If you had one index fund and one actively managed fund, the probability of out performing the index fund over 1 year is 43%.  Over 5 years the odds drop to 31% over 5 years, 25% over 10 years and 13% over 25 years.  The problem lies in how to choose the manager in the 13%.

Now here is where it gets interesting.  Almost no one owns just 1 actively managed fund.  As my friend Greg said last night, the more actively managed funds you own, the more you look like the market average, e.g. the index.  BUT, you have higher expenses to rob your performance. 

So what do the probabilities look like for 10 funds?  The chances of beating an index portfolio over one year is 29%, over 5 years 11%, over 10 years just 6% and over 25 years only 2%.

What is the take away?  Finding positive alpha (out performance over the market index) is very hard.  Finding managers who can deliver consistent positive alpha is even harder.  Most people are best served by investing in broadly diversified index funds.  Over 25 years they will out perform 98% of the actively managed funds.  Pretty good company to be in if you ask me.

In my next post I'll talk about some of the different kinds of index funds that are available.