2. The Case Against Mutual Funds

This is part two of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part one.

I knew I did not want to invest in individual stocks myself, but I still thought that  picking the right stocks at the right time was the only way my retirement portfolio was going to grow.   Personally, I was not confident that I would find an edge over other investors or even that I would be able to overcome the human tendency to want to sell low and buy high – the opposite of good trading.  But I figured some savvy broker with a Harvard MBA would be able to.  As a result I started looking into actively managed mutual funds.  Mutual funds are an investment vehicle that pools money from individual investors and leaves it in the hands of the fund manager (the savvy MBA type).  This fund manager’s only job is to make money for the investors in this fund.  Usually he or she (most likely a he) will have a team of research assistants and all day they research stocks, bonds, commodities… you name it.  If he has 3 assistants, that means the fund spends an average of 160 hours a week researching the market (compared to the 5 that I would devote to it).  And that’s if they only work 8 hour days.  In other words, mutual funds have the time and experience to make better investing decisions – and get better returns.  Or so I thought.

It turns out that buying mutual funds – a retirement solution that so many people rely on, is one of the worst investment vehicles for your retirement money.  That is in part due to the fees and commissions that are associated with buying some funds (such as loads), but most importantly it is due to mutual funds under-performance relative to the market.  The biggest fallacy in the finance industry today is notion that actively managed funds will outperform the market.

What is “the Market?” When I say that most mutual funds fail to beat the market, what do I mean by “the market?”  The market is an elusive term, but most often refers to the return you would get if you literally bought every stock listed on the S&P 500.  The  S&P 500 is an index made up of 500 stocks selected by Standard and Poors (S&P) to be an indicator of total US Stock performance.  There are many other indexes designed to track the market performance – you’ve probably heard “The Dow” (Dow Jones Industrial) or “The Nasdaq”  or even the Rusell 3000 quoted on news stations. They all represent different ways of measuring the market’s overall performance. The Russell 3000, for instance, is an index composed of the 3,000 largest US traded stocks.  While all of the indexes mentioned above track essentially the same thing, the S&P 500 is often used as the standard benchmark for the performance of US stocks.

There is a lot of debate over what exactly is the average return you can expect from the market over a long period.  But for this post, the exact return that you can expect is irrelevant since the market, over the long term, has proven to be the best type investment that you can make.  The market consistently outperforms other investments such as bonds and treasury bills.  If you interested in the types of annual returns you could expect for each investment type or are skeptical about my claim tat the market is the best investment, see the post on “Average Annual Market Returns.”

Nowadays buying the market is possible because of index funds.  An index fund is a type of mutual fund or ETF (Exchange Traded Funds – more on that in Part 3) that has a portfolio meant to exactly track a market index.  For example, there is a S&P 500 index fund.  That means when you buy this fund, its performance will exactly match the performance of the S&P 500, which will come pretty close to matching the entire performance of the US stock market.  Index funds are considered a form of passive investing (as opposed to active investing) because the managers of index funds make no attempt to make money.  The managers (probably just a computer program) simply aim to make sure the fund’s portfolio matches whatever index it is tracking.

Because of the existence of index funds, achieving the same return as the market takes absolutely no skill whatsoever – since everyone can do it.  As a result, the market returns have become the standard by which all active investing strategies and managers are measured.  In other words, if you are a mutual fund manager and you buy and sell individual stocks all year, yet at the end you have under performed the market, you will look silly.  You could have bought an index fund and sat back in your big comfy leather chair, done absolutely nothing, and would have generated better returns.

Are Mutual Funds really that bad? If you are like me, you would expect that mutual funds would consistently beat the market, but it turns out that they don’t.  One of the best books I read exposing this truth was The Power of Passive Investing, by Richard Ferri. A main point that the book constantly drums into your head is that 2/3 of mutual funds fail to beat the market. Further more, the average underperformance from losing funds was more than double the outperformance of winning funds.  I’ve stated it as simply as I can here. But let me assure you, there is an entire book full of independent studies to back this up. The image below is one of the most straightforward pieces of evidence in the book.  It shows the performance of the 136 actively managed funds (that invested primarily in domestic equity and have been around for the past 25 years) compared to the S&P 500 index fund.  There is no secret to the numbers, you can find the annual returns for each of these funds online.


Providing evidence of mutual funds underperformance is more than just one man’s crusade.  Even the popular investing site, The Motley Fool agrees, stating that “more than 80% of  mutual funds underperform the stock market’s average returns.”

Why haven’t I heard this before? I know what you are thinking – “If this is true, then why haven’t I heard this before and why don’t more people know about it?”  I thought the same thing.  According to Ferri, the primary reason we flock to mutual funds is because of the massive amount of advertising that is done on their behalf.  You see commercials for financial advisors and mutual funds, but you don’t see commercials for index funds. Most investment companies earn revenue by selling investment products and charging commissions or fees – two things you can’t charge an investor who simply buys index funds. Simply put, its hard to make money off of index funds, so the investment companies wont promote them.  Mutual funds on the other hand, are a cash cow for many companies.

But if the numbers are so terrible, how do they make mutual funds look so good in advertisments?  First, they only tell you the mutual fund return independent of the fees and commissions you will have to pay (Average mutual fund fees can reduce your annual return by 2%!)  What’s more is that advertisements only talk about the winning funds (which as shown above, actually represent the minority of funds).  How many times have you heard about Fidelity’s Magellan fund?  When I think of mutual funds, that’s what I think of, and it was one of the best performing funds of our time – consistently outperforming the market.  Is it really that surprising that you’ve never heard marketing for a fund that underperforms?

There are also a bunch of other tricks that advertisers use. They might compare their mutual fund’s performance to inappropriate benchmarks.  An example might be a mutual fund that had a majority of its holdings in domestic stocks, but had 40% in emerging market funds.  If emerging markets generated great returns and you compared that fund to the S&P 500 (a domestic stock index) it might look like you “beat the market,” when perhaps your emerging market stocks didn’t even beat the emerging market fund index.  Another strategy for advertisers is to give you the line, “why would you want to subject your self to merely average returns when you could have better than average returns?”  And they have a point.  Investing in an index fund guarantees you will get average returns, and investing in a mutual fund could get you better returns.  What they leave out is that getting better returns is not that likely.

Though I was initially skeptical that mutual funds could be that bad, I ultimately couldn’t ignore the data from multiple sources that said the same thing.  Two thirds of mutual funds fail to beat the market.  So if you can’t beat the market with a mutual fund, then why not just buy the market?

To continue reading, follow the link to Part 3 – Asset Allocation.

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6. Portfolio Rebalancing

This is part six of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part five.

In a nutshell, portfolio rebalancing is when you check up on your portfolio at certain intervals of time and make sure that the percentage of each asset class in your portfolio remains close to the percentage that you originally set for it (as discussed in part 3).   Here is a quick illustration: Lets say I bought $1,000 each of two funds for my portfolio – a stock fund and a bond fund – and I want each fund to make up 50% of my portfolio at all times.  After 1 year, my stock fund went up 20% and my bond fund declined 5%.  As a result I had $1,200 in my stock fund and $950 in my bond fund.  My total portfolio value gained a little to become $2,150, but now had 55.8% (1,200/2,150) of my portfolio in stocks and 44.2% in bonds.  Because it is important for me to maintain a 50/50 split in my portfolio to reduce risk I would sell shares of my stock fund and buy shares of my bond fund so that each fund would have half of my new portfolio value which was $1,075 (2,150/2).  This is called portfolio rebalancing.

I’ll admit its not a very sexy topic, but it is one of my favorite parts about retirement investing because it takes the human element out of your decisions.  The beauty of rebalancing is that you never try to time the market, and you never have to guess about where its going.  If you choose to rebalance every year (a good strategy), then you can buy funds in january and not worry about a thing until december comes along.  Then in january you don’t even have to “research” the market, you just buy or sell funds to make sure that all the assets in your portfolio make up their proper percentage.  Why do I love taking the human element out of the equation?  Based on my own experience and plenty of data, we only get in our own way when we try and “time the market.”

Are humans really that bad at market timing? Dalbar Inc. is a Boston based research firm that publishes an annual report called the QAIB or Quantitative Analysis of Investor Behavior.  They charge $99 to see the annual report, so I haven’t seen it with my own eyes, but I did read a book called It’s Not about the Money by Brent Kessel which described a recent QAIB report.   According to the book, the report studied the actual returns of all investors in equity mutual funds from 1987 to 2006.   The report showed that the average investor would add money to their investment account when the market went up, and then take out money when the market went down.   As a result of this behavior, the typical investor grew $10,000 into $23,252 in 22 years.  Over the same time period, the S&P 500 grew $10,000 into $93,050.

In this example we are talking about people who are simply investing in mutual funds – NOT investing in individual stocks.   As I have explained above, mutual funds are essentially index funds, except they have a 1-2% smaller return.  So what this study is really saying is that the reduction in gains is not a result of picking the wrong stocks, but simply buying and selling at the wrong time.  Its just human nature to want to trade too much and  to go after the “hot fund.”  Its almost like we can’t help ourselves from selling low and buying high – and that is why portfolio rebalancing at set intervals is so successful.  You won’t worry about getting in your own way.

Investor opinions during the recent market slump in 2009 and subsequent recovery also provide an excellent example of how challenged humans are in making the correct investment decisions.   According to a Gallup poll from March 4th 2009 –  just a few days before the market bottom  – only 18 percent guessed that the stock market would recover by year end.  As it turns out, the S&P 500 gained 67 percent from its low point on March 9th until the end of the year meaning just 18% of Americans guessed right.  The poll results from the above link are posted below:

How often should I rebalance my portfolio?  I was so in love with the idea of portfolio balancing that I was ready to rebalance my portfolio once a month.  I wasn’t sure how I was going to make the numbers work – because as explained in part 5, the commissions associated with making 10 trades a month were pretty high.  As it turns out, there really is no right answer – there are studies that show monthly rebalancing to be the most effective, and other studies that show annual rebalancing to be most effective.  Still other studies suggest that its not the time period that should trigger your rebalancing but whether your original asset allocation is broken by a certain percent (like 10%).  Regardless of time period or other method you choose to trigger your rebalancing, the important thing is to come up with some way to adjust your portfolio that will take any emotion or attempt to time the market out of the equation.

Based on my research it seems like rebalancing your portfolio annually is a safe approach.  But just because you rebalance annually, it doesn’t mean you should be putting money into your retirement portfolio only once a year.   As I explained at the end of Part 5, once a year investing reduces your return because your money wasn’t in the market getting 8% a year, and is risky because you are not paying yourself first.  So in the end, even after taking into account annual rebalancing, it is still important to put money into retirement once a month – which means there is really no way to avoid paying large amounts of money just in trade commissions.  With this realization I decided to revisit target date funds.

To continue reading, follow the link to Part 7 – The Solution.