What is the problem?

For some reason I always thought that I need an expert to make investment decisions for me. Investing seemed to complicated from the outside; so it felt completely logical to have someone more experienced pick stocks and funds on my behalf.

I clearly remember the first call I had with a financial consultant at my bank. I was around twenty years old and had some savings that I wanted to invest. Calling and asking my bank for help seemed like the most obvious choice. Long story short, the consultant advised me to buy some of the bank's own funds and I said:

"Let's go for it"

Now, I have to say that the advisor did not mean to scam me or telling a lie; but it is part of their own benefit not to tell the whole truth about investing (unless they are obliged by banking regulations). As a beginner investor, there are few truths that remain hidden from your eyes when you pick other people to choose investments for you.

man looking at marketing analytics
Photo by Adeolu Eletu / Unsplash

# Large and Unpredictable Costs

Financial advisors just show you the returns on their recommended funds before any tax, management cost or inflation is taken into account. It is like showing you the full amount on the pay check before taking a big chunk of it for taxes or other associated costs/benefits.

There are few types of costs associated with this type of investment (which we call active management):

  • Managing cost: You do need to pay them a percentage of the overall portfolio which should be around 1.3% - 0.5% / per year
  • Trading cost: Your fund manager will likely buy/sell stocks and funds on your behalf regularly, which are all subject to costs. We can consider those costs at around 1.5% / per year
  • Tax cost: There is no escaping taxes on investments . But having actively managed funds tend to yield higher taxes. We can consider this at around 1.2% / per year

Now imagine that we have a healthy 9% return on a good portfolio in the stock market (which does not happen ALWAYS). So with that, you can expect to pay around 1/3 of your gains to someone else. With the above costs, you can clearly see that financial advisors have an incentive to push you in buying/selling more funds. This is a sad truth.

Also the situation gets worst when we consider a long term investment which is subject to the compounding effect of these costs on the overall portfolio. You will get less and less rich as the years go by.

# Relying on emotions and prioritizing self-interest

When someone does a service for you, there has to be some sort of compensation for that service. This is fine for most of the people who are performing services, but I feel there is more room for shady practices in active management of funds.

For instance, since the fund manager's compensation is tied to the net value of the portfolio and not on other potential streams of revenue like dividends; prioritisation of the the manager's self-interest might come into play at the expense of the investor.

Additionally, fund managers are incentivised to trade stocks and funds regularly; as they can get commission on transactions. This also means that you become part of the emotional roller coaster, which is the stock market in short term. Stock market can be fantastic in the long run as it will reflect a more accurate picture of the economy's growth. However, stock market in the short term is impacted by a lot of emotions and speculations. Unless your fund manager is a true superstar, it is very hard to always come out with positive returns in stock market's short-term intervals impacted by very emotional investors.

Show me the solution

As always the simplest solutions are always the best for the majority of people. And that simple solution for beginner investors is index fund. There is no speculation when it comes to index funds. You are just buying the whole stock market (or a sub part of it) and holding on to it for a long period of time. In this way, your return will reflect the overall outcome of the stock market. Pretty neat, right?

Let's see how do index funds resolve the issues we raised above about the actively managed funds.

Daytrading bitcoins financial markets at a coffeeshop.".
Photo by Austin Distel / Unsplash

# Low and Predictable Costs

We can now compare index funds's associated costs with actively-managed funds.

  • Managing cost: There is no financial consultant picking, buying and selling stocks for you in index funds. The average cost of index funds is just around 0.1% / per year (compared to 1.3% - 0.5% / per year for actively managed funds)
  • Trading cost: There are no trading cost when it comes to index funds. The whole idea is to buy and hold them. (We will not get into Exchange-Traded Funds or ETFs here as they are subject to costs)
  • Tax costs: You can also expect to pay less tax on your index funds. Average tax costs for index funds is around 0.5% / per year (compared to 1.2% / per year for actively-managed funds)

# Void of emotion and self-interest

The whole idea of index fund is to stay away from constant involvement of people. So by default, it is not impacted at all by emotional investors who can bring the price of stocks up or down. An index fund that tracks the whole market will reflect the growth of the economy.

As for the self-interest, again the whole idea of index fund is to avoid speculations. In this way, index funds are bought and held for long periods of time; so there are no regular costs or fees that might motivate people to take benefit from them.

Conclusion

Index funds are great for an investor who is risk averse and look for a simple solution on how to handle their investment. Whoever invests in index funds can be certain of its low cost as well as its void of human emotion or self-interest. In this way, an investor has a safe investment which can have a higher return compared to someone who always tries to beat the market by actively buying/selling stocks and funds, but carrying a lot of costs and associated risks as well.

Resources

The Little Book of Common Sense Investing
“There are a few investment managers, of course, who are very good - though in the short run, it’s difficult to determine whether a great...
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