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:
- Find a single low-cost fund that invests in multiple index funds, approximating the asset allocation you desire.
- Open up an account (either an IRA or a regular taxable account) with the provider this fund.
- Set up regular, automatic contributions from your checking account to this new account, investing in your chosen fund.
- 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!
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