How to Beat 80% of Investors With 1% of the Effort

how to beat 80 percent of investors with 1 percent of the effort

What if I told you that you could spend about 30 minutes setting up an investment portfolio that would beat 80% of the investors out there without any additional work?

Sound a little too good to be true?

It’s not. Let me explain.

A new study with an important new take

It has been well documented that, on the whole, actively managed funds underperform their indexes year after year in almost every asset class. It’s also been shown that the managers who outperform over one period are not likely to outperform again over the next period. In other words, the probability of the experts consistently outperforming the market period over period is less than chance. These results argue strongly in favor of using index funds to build your investment portfolio instead of trying to beat the market.

Now there’s a new study by Rick Ferri and Alex Benke that takes this conclusion even further. While the above information is very powerful, it has a weakness in that it compares single funds to each other while almost no one invests only in a single fund. People typically have an investment portfolio with multiple funds to represent multiple asset classes. The above data does not address whether a portfolio of actively managed funds is likely to outperform a portfolio of comparable index funds.

This new study looks back at the last 10-16 years and compares the performance of a portfolio of actual index funds to similar portfolios using actively managed funds. It attempts to answer the question of whether you are better off investing in index funds or trying to pick stocks, bonds, etc. that beat those indexes when building a diversified portfolio of investments.

The high-level results

The study had several findings, but the main takeaway is that you are better off investing in a portfolio of index funds than a portfolio of actively managed funds. There are also two main factors that would increase this advantage:
1. The longer your investment time period, the more advantageous index funds are.
2. The more funds you want to invest in, the more advantageous index funds are.

As one example, the authors looked at a very basic portfolio allocated 40% to US stocks, 20% to international stocks and 40% to US bonds over a 16-year time period. They made one portfolio matching this allocation with index funds readily available to the general public. They then simulated another portfolio with the same allocation using randomly selected active funds. Over the course of 5,000 randomized simulations with different combinations of active funds, the index portfolio won 82.9% of the time.

The implication here is that by sticking with index funds in this simple three-fund example, you would outperform someone using active funds over 80% of the time. And the longer you’re investing and the more kinds of funds you want to include, the more advantageous an indexing strategy will be. In one of their simulations using 10 funds instead of 3, the indexing strategy outperformed 90% of the time!

How you can use this information to dominate with almost no effort

There’s a very easy way to use this information to your advantage. All you have to do is follow these steps:

  1. Find a single low-cost fund that invests in multiple index funds, approximating the asset allocation you desire.
  2. Open up an account (either an IRA or a regular taxable account) with the provider this fund.
  3. Set up regular, automatic contributions from your checking account to this new account, investing in your chosen fund.
  4. Sit back, relax and watch your investments outperform all of your friends who are either ignoring the need to invest or obsessing over their desire to find the next great investment opportunity.

Examples of a single fund that can accomplish the goal in Step 1 can be found with something like Vanguard’s Target Retirement funds or their LifeStrategy funds (FYI, I receive no compensation from Vanguard. I just think they’re a great company, though you should do your own research). You could actually almost exactly replicate the 3-fund portfolio described above with Vanguard’s LifeStrategy Moderate Growth fund (it has an additional allocation to international bonds, which should only help you). There are other companies with similar products, though they may not be as low-cost.

Once you pick one of those funds and set up your automatic contributions, your work is pretty much done! You can get back to actually living your life, knowing that your investments are not only handling themselves but are doing quite well!

Conclusions

Investing doesn’t have to be difficult. You can be very successful with minimal effort as long as you make sure to follow a few simple guidelines. The strategy above is not sub-par or lazy. Well, okay, maybe a little lazy, but that’s not a bad thing. The research shows that this lazy strategy will outperform almost all others, and with much less effort!

So what do you think? Better results with less effort. What’s not to like?

Photo courtesy of Donna Sullivan Thomson

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Matt is a fee-only financial planner dedicated to helping new parents build happy families by making money simple. His free time is spent building block towers and jumping on beds with his two awesome boys. If you want to learn more, you can go here.

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  • http://www.youngadultmoney.com/ DC @ Young Adult Money

    Any time I can have more success with less effort I’m all for it ;)

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      It’s hard to imagine why you wouldn’t be!

  • Holly Johnson

    Sweet. That is my exact strategy!

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Nice!

  • cashRebel

    Exactly! I try to explain this to my friend but they can’t believe there’s a whole industry devoted to losing to index funds.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      It is pretty ridiculous. Luckily people are starting to understand, slowly but surely.

  • http://www.edwardantrobus.com/ Edward – Entry Level Dilemma

    Now, if only index funds were available in 401(k)’s!

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Some 401(k)’s have them. If yours doesn’t you should talk to HR and recommend some funds they could add. It’s not usually too difficult for them to add fund options, and the worst that happens is they say no.

      • http://edwardantrobus.co.cc/ Edward – Entry Level Dilemma

        I’ll look into that, but both my wife’s and my employer’s 401(k)’s are managed by an outside company. My wife has the option of a variety of target date funds, 4 mutual funds, company stock, and cash.

        • http://momanddadmoney.com/ Matt @ momanddadmoney

          Still worth asking. You never know. Also, the target date funds may or may not be made up of index funds.

  • AvgJoeMoney

    I think one of the main reasons people delay investing is because they think it’s difficult. Surprise!

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I can definitely understand why they think that, with the regular coverage of all the potential financial disaster ahead and the constant advertising of the “best funds”. But the reality is that it can be incredibly simple.

  • John S @ Frugal Rules

    Right on Matt! I think it’s so easy that so many make it so difficult when it really does not have to be. I actually wrote a post on that which’ll be going up next week.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Excited to see it!

  • E.M.

    Sounds good to me! I will be using these tips when I open my IRA account :)

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Good to hear! I’m looking forward to hearing how that goes.

  • Done by Forty

    More evidence that index investing beats active investing — good stuff.

    When I occasionally tell friends about how we invest, they usually respond by recommending a specific stock to purchase (always a winner over the past few years). I never know how to react — it’s like we’re too divergent to really have a conversation about it.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      It can be pretty tough to talk to some people about this kind of strategy. It can seem too simplistic to actually be good. But the numbers don’t lie.

  • Emily @ evolvingPF

    Great summary! We’re in a target date retirement fund, but I’m starting to think I don’t like the exact asset allocation, so I might put a BIT more effort into just directly buying a small number of index funds and rebalancing myself. But ITA that what you wrote about will be a successful strategy.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I switched from a target date fund to our own allocation just about a year ago. It’s a little more personalized and satisfies the control freak in me, though I don’t have any illusions that it will perform better. It may or it may not, but either way it won’t be because of skill. We still only use 4 funds total so it’s still a pretty simple portfolio.

  • JW_UmbrellaTreasury

    Precisely! Maximum (or near maximum) output with minimal energy is a winning combination.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Couldn’t agree more.

  • Jacob @ MPFJ

    Thanks so much for the mention!

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      No problem!

  • Your Daily Finance

    Work smarter not harder! I like this strategy but my wifey doesnt have index funds in her 401k and I personally like picking individual stocks but should look into index funds as well. Before we were both in target date funds.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Target date funds can definitely be a good strategy. Some are better than others. What’s your reasoning for picking individual stocks? Is it simply enjoyable or do you find that you can produce better results?

  • http://Www.Plantingourpennies.Com/ Mrs PoP @ PlantingOurPennies

    We’ve been using Vanguard’s 2045 Target fund for about a decade and are super pleased =)

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I was using their 2050 fund for a while. I just switched out about a year ago simply because I wanted to manage things a little differently. But I would have no qualms at all about switching back. I just have a little bit of a control issue, haha.

  • Greg

    I agree totally. Keeping the money in an index fund long term is the way to go. Plus, it is much easier on my hear than jumping around trying to find the next big thing.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I think people hear that last point you make about it being easier and assume that it must be sub-par. The fact that it’s actually better than average is the real reason to do it, and the point about it being easier is the icing on the cake. Pretty delicious icing if you ask me!

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  • Rob

    Nice analysis, and the link to Rick’s study is really helpful. His book, All About Asset Allocation, is excellent. I invest in both individual stocks and mutual funds. But most of my funds are index funds for all the reasons you mentioned. To me, the real key is to leave your investments alone when the market is going down. Believe it or not, it gets easier after you been through a couple of bear markets.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Thanks Rob. I haven’t read that book yet but it’s definitely on my wish list. I do read Rick’s columns regularly and am continually impressed by the information. Glad to hear that weathering the storm gets easier over time. I hope I’m saying the same thing down the line.

  • Nick

    I would first off be careful as this study is based on information from the past 10-16 years. Not a very good study period. Also probably not long enough. A good chunk of your information is dangerous or can be. People should take all this information with a grain of salt and question many of the financial myths that you bring into these forums. Fear the herd mentality.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I will agree that the time period used is not very long. But all of the evidence we have shows that index investing is a superior approach to active investing. I haven’t seen a single legitimate piece of research demonstrating otherwise. I would be very interested if you could provide some.

  • Roger Wohlner

    Matt good post. I am a fan of indexing I’m not so sure that I’m a fan of using a target date fund to do it, at least if the investor is over say 35 or 40. Using index funds does eliminate the manager risk inherent in actively managed funds and certainly lowers investing expenses. Using primarily index funds in conjunction with an asset allocation strategy based upon a financial plan that takes your unique situation and goals into account may not be the magic bullet, but it is pretty close. It is no coincidence in my opinion that Vanguard (which uses all index funds) is one of only two Target Date Fund Families (T. Rowe is the other) to receive the top ranking from Morningstar in its most recent ranking of TDF families.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Thanks Roger. I certainly don’t think target date funds or something similar are the perfect solution for all situations. I myself don’t use them simply because I want to implement a slightly different strategy. But I would also be fine if my only choices were Vanguard target date funds, and I think that for the vast majority of people using something simple like that is really the best way to go. It’s probably not worth the hassle of trying to manage more funds on their own, and almost certainly not worth paying someone to do it for you unless you have a significant sum of money.

      A good target date fund (as you point out, not all are good) removes a lot of the potential for harmful behaviors, which is really whats stands in the way of success for most investors.

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  • http://www.saveandconquer.com/ Bryce

    Diversify and keep fees as low as possible is my mantra. Vanguard meets both of these criteria. I personally like to use the 3-fund portfolio of Total Stock Market, Total International Stock Market, and Total Bond Market in the asset allocation that is appropriate for the portfolio owner. These three funds usually have a lower combined expense ratio than target date fund expense ratios, even the ones offered by Vanguard.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      If you can get into the admiral shares, or you want to use ETFs, then it’s cheaper to build it on your own. I personally use a slightly different approach, preferring Treasury bonds to the entire bond market, but I think any of the things we’ve talked about here are all great. At this level the differences are pretty minute.

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  • MilesAbound

    I am not going to argue that actively managed funds under-perform indexed funds. I think that has been proven beyond any shadow of a doubt. Of course there will be many clowns who think they can find the top 20% of managers who do outperform, and there will be a small few people who are smart enough to work out who actually has a viable edge, but for the majority the actively managed vs passively managed is quite straight-forward.

    Where I do disagree with the conclusion though is that buying indexed funds is “investing”. Investing to me is the idea of giving money to someone in the expectation that they will do something with that money and pay you a return on that capital. So let’s say I invest in a guy who runs a blog so he can build a better infrastructure, I do so on the basis that the investment will result in increased revenue which now as an equity owner I will share in. Or I know that the government needs to borrow money on a long term basis to fund operation and it can repay me with interest either through tax receipts or inflating the currency. That is investing. Buying an asset in the hope that someone else will later buy it for more is speculating. Now I do give that in theory index funds “invest” in every company and one could argue you are simply investing in the aggregate enterprise value of all companies in a given economy, but in reality people buy an S&P 500 index because they see it at 15k today and they think by the time they retire it will be at 30k or 40k. They think because it has provided compounded returns of x% in the past it will do so in the future. Or they are “conservative” and say well it provided 12% compounded over the last twenty years so I am only going to assume 7% over the next twenty. It is all just mass speculation.

    That is why personally I think the proper way to invest for retirement is in held to maturity, high quality fixed income instruments linked to your retirement period. Admittedly that is harder when you are say 25 as it’s hard to find instruments with 40 year maturity dates, and so perhaps in your 20s more speculative “investment” may be appropriate. But as you get into your 30s and 40s you can start buying individual treasuries and high grade corporate credits that mature when you plan to retire. I can buy 30 year US treasuries today for $0.39 knowing with a relatively high degree of certainty they will be worth $1.00 in 30 years time. Yes they are subject to all kinds of interest rate volatility in the interim but that is absolutely irrelevant. You should be holding the asset until it repays you. This to me is real investment, you know the purpose, you know how you will be repaid and you know how much. The return is not as high as you may want it to be, but the alternatives are purely speculative. Just the speculators cross their fingers whereas my methodology is pretty stable and I can sit back and relax. Sure I have to fund more because my rate of return expectation is so much lower, but it is just more realistic.

    A great example is in Japan. Sure interest rates have been low but anyone following my approach would have all their principal plus some interest growth intact. The speculators on the other hand are invested in the ^N225 index will be sitting on losses whether they started 10, 15, 20 or 25 years ago. Markets do not always rise.

    Of course the real reason very few people invest this way is there is such a large industry around managing money which would make little sense if this is how everyone operated. I see your CFP designation and no disrespect intended but CFPs and CFAs and mutual fund companies and ETF companies would not make money if all we all did was buy bonds. It’s like taxation – the tax prep and advice industry is just too huge for us all to go to what is clearly a better system of simple flat tax rates.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      I think each individual has to choose an investment strategy that they understand and helps them best reach their goals. It sounds like you’ve been able to do that.

      But I think some of your reasoning is off. You say that “in theory index funds “invest” in every company”. Actually that’s not a theory. That is just what they do, so it’s a fact. You also say that “Investing to me is the idea of giving money to someone in the expectation that they will do something with that money and pay you a return on that capital.” I completely agree, and that is exactly what you are doing when you invest in companies through the stock market. Of course there is speculation that creates temporary bubbles as well as temporary depressions, but over time the stock market delivers returns because the underlying companies provide a return on the capital they receive. You might argue that that won’t continue to happen going forward, and I can’t prove you wrong, but it is what has happened historically. No guarantees and all that, but there’s also no guarantee that the US government will make good on your 30-year bond. The bond is certainly closer to guaranteed, but that’s why it has a low return.

      As of 9/26/2013, the yield on a 30-year Treasury bill was 3.69% Let’s say you need $1M in today’s dollars to retire and you want to do so in 30 years. And let’s say inflation will be 3%. You would need to contribute over $45k per year at that rate of return to get there. I agree with you that if you can actually do this it’s a strategy that carries less risk, I just don’t personally think it’s necessary or the most efficient way to do it. But again, each person has to pick a strategy that works for them and I’m glad you’ve found one for you.

      On your point about CFPs in particular, I will agree with you that there are many people selling services or products at prices that do not make sense for what they deliver, particularly if what they’re promising is an investment strategy that will beat the market. But a good CFP provides value far beyond choosing investments and it’s naive to ignore that. I will agree that the various laws, and in particular the tax laws, create business out of certain types of advisory services that ideally wouldn’t have to exist. But CFPs did not create those law.

      Finally, I’m not really sure what you’re trying to get at when you say “if all we all did was buy bonds”. If that was the case, we would have a completely different economy than we have today and everything we’re talking about would likely be irrelevant. So I’m just not sure what you’re trying to get at there.

      • MilesAbound

        I think it’s an interesting debate. By “investing” in an index as you say you are buying into every company and you earn their aggregate return on capital. Many of those companies will never deliver any good return on capital, many will go bankrupt, others will deliver well and others will hit the ball out the park. So ultimately I do not think you are investing you are just speculating that more companies will do better than worse. Or at least in theory, more realistically you are speculating future generations will pay more for equities that you will. And you are basing that quite clearly on the theory that in the past that has been in the case so in the future it will be too. But again I cite Japan as a very clear example of a major developed economy where that has proven wrong on a consistent basis since 1985. And even for me. I started investing heavily in a series of index style funds in 1999 and after a decade the overall rate of return was just under 0%. Sure they have gone back up since, but do I think there is any rationality to their current valuations? No! There is a very high probability that the IRR from 2009 to 2019 will be zero or less again.

        And then you argue that in order to retire comfortably I need a better rate of return than bonds can provide? Ah ok now this is exactly what happened with pension funds, which not so long ago were actually in decent fiscal shape. The original investment model of pension systems was to invest in treasuries and high grade corporate debt matched to the liabilities of the plan. This is called liability driven investment or asset and liability management. It’s very, very simple. I know I need x $’s in y years and I can earn z rate of return on the dollars I invest today. I know exactly how much I need to invest. But what happened is the plans got intoxicated by the returns in the stock market and started funding less money into more risky investments because the rate of return was going to save them. And for years it worked – until it didn’t. And when the markets tanked they all found themselves deeply underfunded. Should have stuck to the original plan. I would never, ever, ever make an investment decision because I felt I “needed” a certain rate of return. I only ever make investment decisions because I am either comfortable with the outcome (the conservative model which is how I play my main retirement planning) or I think the upset significantly outweighs the possible downside (my more speculative investments using money I don’t necessarily need for my long term goals)

        Anyway I only just found this site and I have to say it’s an excellent blog and I like your interaction with readers, very engaging and not dismissive. Bravo!

        • http://momanddadmoney.com/ Matt @ momanddadmoney

          First of all, thank you for the kind words. They are much appreciated.

          I think you make some very good points, the first of which is that investing in the stock market carries a very real risk that many people just kind of gloss over in the search for higher returns. That’s actually something I’ve written about recently (http://momanddadmoney.com/the-real-risk-of-investing-in-the-stock-market/). Your Japan example is one where investors have certainly not seen the kinds of returns from the stock market that they would have expected. That’s a very real risk and it’s the reason why people should think seriously about what kinds of risks they are willing to take and then diversify.

          I also wholeheartedly agree with your point that you should “never, ever, ever make an investment decision because I felt I “needed” a certain rate of return”. That is not at all what I meant to convey. What I think IS important is to understand the risk/reward opportunities of your different options and choose one that meets your needs. That will determine a ballpark expected return, and I would round down to be conservative and then figure out the needed contribution. My point with bringing up the required contribution of your plan is simply that, while I understand and respect your reasoning, I personally don’t think it’s necessary for most people to go that extreme. Your plan is on the extreme end of low risk/low return, and that’s a fine personal choice, but there are other viable options.

          But I still disagree with you on the idea of index investing actually being investing. The whole point of using a broad index fund is that you don’t know which companies will tank and which will succeed, but on the whole you believe that the businesses making up the world economy will continue to provide value. You don’t personally have to believe that (it seems like you don’t), but there’s a long history of that being the case and it’s therefore a completely legitimate place to put your money and expect a real return. Of course there will always be speculators looking to make a quick buck, but that does not describe everyone who takes this approach.

          I also want to warn against the popular concept of the “lost decade” in the US stock market that you are putting forth here. It is true that the price-level of the stock market did not rise, but dividends were being paid the entire time. When you factor in the dividends (and I sincerely hope they were reinvested), then there in fact was a positive return. It certainly was not the bull market that people had come to expect, but it was better than much of the popular media makes it out to be.

  • Buck Inspire

    Late to the game, but great post! I think human nature likes to complicate things. Ego and emotions get involved and we actually hurt ourselves in the process. Index funds, simple, and logical can’t compete with active, complicated, and sexy. Investors should focus on the bottom line rather than trying to outperform others!

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Totally agree. For some reason we like to think that something has to be difficult or complicated for it to be good. That just isn’t the case with investing. Simplicity often rules the day.

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  • This Life On Purpose

    Index funds are the way to go! And the fact that it’s a simple as that makes it that much more appealing to me.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Right on!

  • http://debtblag.com/ Debt BLAG

    I don’t think it’s lazy at all. It takes a lot of mental effort to overcome our assumptions and arrive at this conclusion. Well done

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Good point. Lazy probably isn’t the right word for it. Simple is probably better. But it certainly isn’t always easy.

  • Jon Brooks

    Hi Matt! I see two issues with the study – one is that there is a time period bias meaning that the study did a screening of historical data to find results that matched its inputs (high returns on passive portfolios). The screening was looking for the best length of time (16 years) to have invested in index funds. This means that the study was biased from the start.

    Second, the study uses historical data and going forward it may not make sense for an investor to be in index funds, especially if they are buying when the market is overvalued.

    While I agree that long-term investing in passive portfolios is good for many people who don’t have time for due diligence, I can also see issues with it. For example, when the market loses 20-30% of its value over a few months and people lose their jobs, they have to sell out of their investments at a low to get by. Passive investing can be very painful in those circumstances. When the market goes down, correlation tends to go to 1.

    What do you think?

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Hi Jon. Thanks for the input. I have a few thoughts.

      First, I agree with you that the time period is short and that that needs to be taken into consideration. However, I don’t think it’s a bias so much as it’s using the data we have. The point of this study was to look at actual index funds available to regular investors rather than to just compare active investors to indexes that no one can actually use. The reality is that those index funds have a limited history and the researchers went back as far as they could. So yes, there is some limitation there. But no, it is not an example of bias.

      Second, I’m not sure why you feel that this period was particularly biased towards passive funds. The time period saw multiple bull and bear markets, which should have given skillful active investors plenty of opportunity to show their stuff. The fact that they weren’t able to speaks volumes.

      Third, yes you are correct that past results are no guarantee of future performance. But I think the implication that people can make simple decisions about things like the market being “overvalued” is wrong. There is simply no credible evidence that market-timing works. All of the credible data we have at this point shows that a market-based passive approach is better than the alternatives. No, there is no guarantee that will continue to be true. But until there’s a viable alternative presented (maybe you’d like to suggest one?), it’s the best we have to go on.

      Fourth, I’m not sure where you conclusion that people have to sell their investments when they lose their jobs comes from, and what relevance it has. I would recommend that people build emergency funds to specifically avoid this need, but for those who don’t I don’t see any difference between being invested passively or actively. If you don’t have other funds, you would have to sell your investments either way. So I’m not sure what your point is here.

      Finally, what I would really appreciate is a thoughtful argument on why you think a different approach is better. I’m always happy to hear other opinions, especially when they’re backed up by some good data.

      • Jon Brooks

        Hi Matt, thanks for the response! I’m always open to a good debate on active vs. passive investing, it is a debate that goes on today, that we had multiple times while I was an intern at GS, and is very important to the investment world. Even Nobel Laureates Eugene Fama and Robert Shiller, who spoke at the Swedish Embassy in DC last week, made public comments about their differing stances.

        I personally agree with Shiller’s stance – that the market can be over-valued or undervalued based on fundamentals and earnings power. He believes in behavioral finance and herd mentality, which I also agree with (like posting about how easy it is to invest in passively managed indexes while the market hits new highs). This COULD prompt mom and pops to jump in at a time where the risk/return profile of equities is not favorable (Yes you could say based on history that 3 specific index funds outperformed actively managed funds, but this is (1) based on history in a specific time period and (2) is only representative of those 3 funds, and (3) is not and should not be used as a predictor of future performance). Of course, that is just my opinion. But what is not opinion is that the price for the amount of earnings for S&P 500 companies is 50% higher than the historical average (Shiller PE Index).

        Is it prudent to advise passively investing in a market where price-to-earnings are 50% higher than the historical average? You would probably call this conclusion market timing – but what it really does is lowers your risk. Basic finance tells us the less we pay for something the less risk we have. Right now, buying a passive index fund that mimics the market, has higher risk, than the historical average.

        1. Thanks for agreeing there are many limitations to the study.

        2. There is a possibility of bias because the study is limited to specific time period and it only includes 3 passively managed funds (that were actively chosen). Many actively managed funds did perform well during the same time period. The study does not address in detail that even though those 3 actively chosen passively managed funds outperformed in those specific periods, the extend to which they outperformed, was pretty minimal.

        3. I don’t think there is one right strategy that will work 100% of the time all the time. Hind-sight is 20-20, and strategies should evolve as the market changes. I do believe, however, if you do your due diligence, you can better your odds of not buying over-priced stocks. One way to improve your chances is to minimize the price you pay for a company relative to its earnings using simple tools like the P/E ratio.

        4. Many people do not have emergency funds, or saved enough to withstand long-term unemployment. So they sell their investments to pay for their current expenses. This is what happened during the 2008 financial crisis, and passive investing and emergency funds did not save them, but the emergency fund probably helped. If the investor was actively managing their funds AND looking at fundamentals like the P/E ratio of the market, they could have avoided some or all of the crash. Some investors, because they did their diligence, saw the crash coming, and got out. The key is that they did their due diligence. Of course, many investors got caught up in speculation, while the market got away from fundamentals – passive investors were just going along for the ride. Even when passive investors do not have to sell to cover expenses, they often sell out when they see big losses, because they are upset. This gets them out at the bottom of the market when everyone else is buying. At that moment, they should likely be buying more. As J.P. Morgan once said “the time to buy is when there is blood on the streets, even if it is your own blood.”

        I am too, happy to hear opinions based on unbiased data that arrives at well thought out qualitative and quantitative conclusions!

        • http://momanddadmoney.com/ Matt @ momanddadmoney

          Unless you’re talking about something simple like value investing (which I don’t personally practice, but I understand the evidence in favor of it), then the approach you’re talking about with evaluating P/E or some other indicator of value is market timing. And while the kind of rhetoric you use here can sound very convincing, I have yet to see any evidence that it can actually be put into place with any consistency and effectiveness. Again, if you would like to offer some data showing otherwise, I would love to see it.

          Also, you keep bringing up this point about the study only looking at 3 passively managed funds, which I think is obscuring the larger point of the research. Picking 3 index funds that mimic widely established indices at a low cost is not anywhere near the same thing as picking 3 active funds that happened to do well over some arbitrary period of time. The point here is that we’ve known for a long time that actively managed funds trail the indices. Now we can see that they also trail real live index funds that track those indices. There’s no bias there in picking only three funds, as they’re simply representative of any fund that tracks its index well. Those funds are simply chosen because they do the job they’re supposed to do, which is track the index. Going forward there’s no reason to expect that they will suddenly become bad at tracking the index, so again I don’t see what the problem is.

          Once again, I would ask you for a clear argument on what kind of strategy you would prefer. And once again, data, not rhetoric, is preferred.

          • Jon Brooks

            I see your point about the indexes – it is under the assumption those indexes reflect the average investor’s mix of debt/equity and investment strategy of US equity/International equity/US investment grade bonds. Yet it would be interesting to see the results for direct comparisons of passive and active funds in terms of fund style (international, US, small cap, large cap, etc.). Do know you of any studies that do this? It would also be interesting to see how the results would change in this study if the debt/equity mix changed.

            This being said, I know most studies show the similar result that passive management is better over the long-haul +/- 1% a year. Yes, that can add up to a lot over time. But the problem with this is that it implies passive investors don’t get emotionally involved and sell out during crises, which are part of the normal business cycle. Yes, selling out means that you are breaking the passive investment law of being passive. It would be great to see some statistics on how many passive investors sell because of fear when the market is nearing the bottom, or don’t change their investment profile of bond/equity mix for 16 years straight.

            Instead of being completely passive and giving 1% of your effort to your long-term financial stability, I think if you are going to go passive you should at least follow the market to the extent that you understand the risk of the market, using fundamental indicators like the P/E ratio as a guide. That way you know the amount of risk you are taking, relative to return, as the market moves on. If you have been passively invested up to today, I believe it may be a good time to take gains because the risk/return profile for equities is not favorable going forward based on fundamentals. I feel that investing should be based on risk, not on laziness/effort. The major risks I see with passive investing is selling out before the magic 16 year period or during financial crises and the investor’s need for and timing of future cash flows.

          • http://momanddadmoney.com/ Matt @ momanddadmoney

            It’s not that the indexes represent the average investor’s asset allocation. It’s that each individual index fund tracks its index well (i.e. the US stock index fund closely tracks the US stock market, the US bond fund closely tracks the US bond market, etc.) As long as they track the indexes well, then they are representative of what any good index fund can do. The specific mix of those index funds into an asset allocation is one of the decisions each individual investor has to make based on their risk tolerance. The 40-20-40 split in this study is simply one example out of many.

            And in fact there are multiple studies that look at different styles, as you ask about here. This study actually does just that as well. In addition to that 3-fund portfolio, they look at a 10-fund portfolio with more of a slice-and-dice strategy as you describe and found that it outperformed similar active strategies over 90% of the time, even better than the 3-fund portfolio. SPIVA also produces regular reports comparing active funds to their indices (not actual funds) and the active funds consistently come up short. You can find them here: http://us.spindices.com/resource-center/thought-leadership/spiva/

            I think we can agree that emotions play a significant role in investing, but I would say that’s true whether you take an active or a passive approach. It’s why I preach consistency through the ups and downs as a hallmark of successful investors. I don’t that any one strategy guarantees that individuals won’t act rashly, but I also don’t think there’s any reason to believe passive investors are more likely to do so than active investors.

            I also agree with you that investors should consider the risk of their investments and choose a strategy that aligns with their desire and need to take risk. But I think that’s a decision you make at the outset and only adjust either because of big life changes or because your experience shows that your risk tolerance is different than what you thought. It’s not something you adjust based on current market conditions.

            The big issue I have here is the rhetoric you use to try and disparage a passive approach. You first call it lazy, which couldn’t be further from the truth. A whole lot of time and thinking has gone into the research demonstrating the benefits of a passive approach. It would be lazy to make investment decisions based on words that sound good but have no data behind them. It’s simply smart to make decisions based on the best information we have available, which is that in the large majority of cases sticking with a consistent, index-based approach will give you the best chance for success.

            You also try to say that the 16 year period represents a “magic” period that if you miss you’re out of luck with a passive approach. This kind of wording has no basis in any kind of fact, other than the period in the study was 16 years. But there’s nothing magic about it, it’s just the full amount of data available, which again ran through multiple bull and bear markets which if anything should have given all the good market timers plenty of opportunity to show how good they are. Unfortunately, it didn’t work out for the market timers. Maybe next time.

            If you’re insistent on using market timing with your investments, I sincerely wish you the best of luck. I hope it works out for you and it makes you a lot of money. I will continue to avoid it and will speak against it until there is credible evidence that it can actually work.

            As a final note, I’m not sure what value continuing this discussion can have unless you have some actual research that backs up your opinions. If so, I would love to see it. Otherwise, I wish you the best of luck. Thanks for adding to the discussion.

          • Jon Brooks

            Overall, I think it is bad advice to stay passive in an overvalued market, where risk/return in minimal. If you don’t believe in changing asset allocations/classes according to market conditions I wish you the best of luck as well as over the next few years.

            Investors retiring soon who hold a large portion of their portfolio in bonds and in high dividend paying stocks, please be careful going forward! I don’t think passive investing will be the best option for you from here on out. Interest rate cycles tend to go for extended periods (20-30 years), and your investments are likely to lose value in coming years if you don’t hedge or adjust your asset allocation.

            Here’s a pretty good chart of the history of interest rates from Yahoo.com/finance:
            http://finance.yahoo.com/blogs/talking-numbers/222-years-interest-history-one-chart-173358843.html

            Thanks for the conversation and best of luck! Always good to hear a well responded to passive argument :).

  • jenny leow

    I read about all the good things about Vanguard. But I am not a citizen of US or reside in the country. Can I still invest?

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Hi Jenny. To be honest with you I’m not very familiar with Vanguard’s policies for international investors. I did find this page on Vanguard’s site though which may be helpful: https://global.vanguard.com/portal/site/home

      Good luck!

      • jenny leow

        Hi Matt, thank you for your kind help, With the link provided, I have contacted the Vanguard in Singapore – Asia. They come back with the below, ” Please note also that our US mutual funds are authorised for sale only to US investors. We are not currently registered to distribute our funds to retail clients in Singapore and do not have the capability in Singapore to open accounts for direct retail investors. ” Meaning no way I can invest in Vanguard unless I am a US citizens :( Just gonna find other mutual funds then…. Thanks again !!!!

        • http://momanddadmoney.com/ Matt @ momanddadmoney

          Sorry to hear that Jenny but thank you for providing the feedback! I’d love to hear what solutions you do find out there. Hopefully there’s something useful.

  • http://survivethevalley.com/ Survive The Valley

    I’m with you. I’m doing weekly automatic investment in broad funds using Betterment and Wealthfront. So far so good… and best yet… I don’t have to expend any more energy than I absolutely have to keeping track of my investments.

    • http://momanddadmoney.com/ Matt @ momanddadmoney

      Sounds like a good approach. Do the investment strategies of those companies fit what you already wanted, or did you have to compromise a little on strategy? I’d love to hear your thought process there.

      • http://survivethevalley.com/ Survive The Valley

        Thanks, Matt. Yes, their strategies fit my own.

        From a high level I’m all about passive dollar-cost-averaging investing and sticking with low cost ETF funds that mimic indexes – which have been proven to outperform pretty much all mutual funds over the long term (and I’m in it for the long term).

        Both Betterment and Wealthfront go a step further from simple index investing and also allocate your investment across multiple asset classes: up to 8 for Wealthfront and up to 12 for Betterment. Then they monitor your portfolio and do automatic rebalancing for you in case an imbalance occurs. Wealthfront also does automatic tax-loss harvesting for taxable accounts over $100k, which could be helpful to reduce your tax bill by offsetting gains with losses at the end of the year.

        Both services also take into account your individual risk tolerance and they adjust your portfolio accordingly. So on my own I might just buy a S&P500 index fund, but with both services if you want to dial down the risk a little they will reduce your exposure to equities and put some of your allocation toward bonds.

        Finally, having everything automated is a big plus for me!

        • http://momanddadmoney.com/ Matt @ momanddadmoney

          Sounds good. Personally, I want a slightly different kind of asset allocation than what each of them does, but I do think they’re great services, particularly if you already believe in their investment philosophy. And I don’t really think that I’ll perform materially better over the long-term. It comes down more to comfort level than anything else. But I think companies like Betterment and Wealthfront are doing investors a great service.