Last week I went to my friend’s bachelor party in Montreal. As we were sitting together late night at the blackjack table, happily giving our money away to the dealer, the subject of making responsible financial decisions came up and he mentioned that he has a guy who manages his investments for him.
Now, I usually try not to be a know-it-all when this stuff comes up with my friends because, well, that’s super annoying. But he brought it up and this is a topic that hits home for me, so…
I asked why he pays this guy to invest for him. And he essentially gave me three reasons:
- My friend doesn’t have the time or knowledge to do it himself.
- It’s this guy’s job, so he knows how to do it right.
- It’s fair to pay someone for a service if they can do it better than you can.
All good points. All completely logical. And in just about any other situation that would be a perfect answer. End of discussion.
But investing works differently.
You don’t need to pay someone to manage your investments for you. In fact, you may be MUCH better off doing it on your own, and it doesn’t have to be hard or take a lot of time.
Here’s how to beat 80% of investors with 1% of the effort.
The failure of active investors
Before getting into the how, let’s quickly talk about the why.
In 2013, Rick Ferri, CFA and Alex Benke, CFP® released the results of a study where they compared the performance of actively managed investment portfolios to those of index-based portfolios.
The actively managed approach relies on the skill and expertise of investment professionals to generate superior returns. The index-based approach relies on mutual funds and ETFs that simply track the market.
What they found was pretty incredible.
Despite all of their training, all of their knowledge, and all of the time spent trying to find the best opportunities, the investment professionals repeatedly failed to beat a simple index-based investment strategy.
For example, when Ferri and Benke evaluated a simple three fund portfolio made up of US stocks, international stocks, and US bonds, they found that the index-based portfolio outperformed the actively managed portfolio 82.9% of the time.
Not only that, but the professionals typically underperformed by 1.25% per year. And the small number of professionals who managed to outperform the market only did so by 0.52% per year.
In other words, not only were there far fewer winners than losers, but the losers lost by much more than the winners won by.
Now, you could argue that a three fund portfolio is too simple and therefore not a fair comparison. After all, most investment professionals create more complicated portfolios in an effort to capture extra returns and limit the downside risk.
Luckily, Ferri and Benke looked at that scenario too.
What they found was that the more complicated you made the portfolio, the more likely it was that the index-based strategy would win. For example, when they looked at a 10-fund portfolio that included a wide range of asset classes, the index-based portfolio produced better returns 89.9% of the time.
The big breakthrough here was the realization that combining index funds in a portfolio increases that advantage even further.
That finding has some pretty powerful implications for you as you create your own personal investment plan.
How to dominate your investments with minimal effort
So now we know this: simple, index-based investment strategies outperform professionally managed investment strategies 80-90% of the time.
But what does that mean for you?
After all, that knowledge alone isn’t enough. You still need to create, implement, and manage an investment strategy that utilizes that information in the right ways to help you reach your investment goals.
And that still sounds like a lot, right? Isn’t that where the professional help comes in? Isn’t the point of paying someone so that you don’t have to spend all the time and energy learning and managing this yourself? So that you can do it the right way with minimal effort?
A few years ago I probably would have said yes. And there are still situations in which getting professional guidance can be incredibly helpful.
But you should also know that it’s easier than ever to create, implement, and manage an index-based investment plan on your own that not only increases your odds of getting good returns, but requires minimal ongoing effort on your part.
Here are a few ways to do it.
1. All-in-one funds
Most investment companies now offer all-in-one funds that are essentially an entire investment portfolio in a single fund.
For example, Vanguard offers its LifeStrategy Growth Fund that looks like this:
- 48% Vanguard Total US Stock Market Index Fund
- 32% Vanguard Total International Stock Index Fund
- 14% Vanguard Total Bond Market Index Fund
- 6% Vanguard Total International Bond Index Fund
With a single fund, you get access to the entire world of stocks and bonds. You never have to worry about rebalancing, since the fund does that for you. And the total cost is only 0.15% per year.
This is as easy as it gets. Literally all you have to do is find a fund that approximates your target asset allocation, set up automatic contributions to that fund, and you’re done! You’ve created an index-based investment strategy that requires almost no ongoing work and, according to the research, has an 80-90% chance of outperforming the professionals.
The big “but” here is to watch out for costs. Some of these all-in-one funds are more expensive than others, and since cost is the single best predictor of future returns, this is something you’ll want to pay attention to.
Robo-advisors are automated investment platforms that perform essentially the same role as a good all-in-one fund. They create and manage the investment portfolio for you, meaning all you really have to do is set up your contributions and let the platform do the rest.
On the plus side, the good ones make it easy to get started, give you access to a top-notch index-based investment portfolio, and cost much less than an investment professional.
On the down side, they cost a little more than using one of the best all-in-one funds.
You can read more about the pros and cons here, but the big takeaway is that the good ones are really good. Honestly, a platform like Betterment gives you access to essentially the same type of portfolio that most good investment managers have been using for years at a fraction of the cost.
Of course, you don’t have to rely on someone else to do it for you. If you have a specific strategy you’d like to implement, and if there’s no all-in-one fund or robo-advisor that does it, you can pick your own funds and manage it yourself.
This obviously requires more work than the options above, but it doesn’t have to be much more. And anyways, the only reason to go this route is if you have a strong conviction about a particular investment philosophy, which means you probably nerd out on this stuff and are okay with a little extra work!
And the good news is that going the DIY route is easier than ever. There are more low-cost index funds available than ever before, with plenty of easy and free ways to access them.
For example, you can trade Vanguard funds for free if you invest with Vanguard, and the same is true with Fidelity, Schwab, and many of the other major fund companies. And if you’d rather mix and match, many trading platforms offer a strong lineup of commission-free ETFs so you can choose the best from each investment company.
Honestly, after that initial work, it doesn’t have to take you more than 15-30 minutes PER YEAR to manage. And you can save yourself a heck of a lot of money.
How much money will you save?
You might read all of this and think to yourself: “You know what? I get all of that, but 1% isn’t very much to pay someone to just do this for me, and at least that way I’ll have the peace of mind of having a professional in my corner.”
Fair enough. So let’s look at just how much that 1% could be costing you.
I created this simple spreadsheet to run the numbers, and you can grab your own copy to run them yourself if you’d like.
Here’s what I assumed:
- You’re starting with $50,000.
- You’re adding $11,000 per year (the max combined IRA contribution for a married couple).
- You get a 7% annual return.
- In one scenario, you choose Vanguard’s all-in-one fund that costs 0.15% per year.
- In the other scenario, you use a professional who charges you an additional 1% management fee.
In this example, after 20 years that extra 1% fee will cost you $77,708. After 30 years it will be $254,122. After 40 years it will be $695,232.
That’s a lot of money! And if you’re starting with more money and/or contributing more each year, the difference will be even higher.
The point here is that even a small fee can cost you a lot of money. Are you willing to pay hundreds of thousands of dollars to someone without really knowing what they’re doing for you?
Don’t waste your money
There ARE good reasons to get the help of an investment professional. More than anything else, a good one will help you create a plan tailored to your specific goals and stay on track when the going gets tough.
But you shouldn’t blindly assume that it’s worth paying someone 1% or more of your money every single year just to manage a portfolio for you. The tools available to you these days are too good, especially when the potential cost of ignoring them is so high.
Unless your “investment guy” is doing substantially more than choosing some funds and rebalancing every now and then, it’s not worth wasting your money.