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A few years back, I approached my father-in-law’s financial advisor to understand why the his returns were so poor. He was a family friend and had been managing the family’s money for a long time. I just couldn’t understand such paltry results year after year when looking through the financial statements. So, I had a meeting with him. At that time, I asked him what he benchmarked against. This is when the tap dancing began. He used phrases that he thought I wouldn’t understand like “asset allocation” and “diversification of the portfolio through alternative measures”.
That’s when my probing questions began. I wanted to know if he really understood the models and their indicators, so I asked him why he bought a European Gold Fund and American Gold Fund, and if he would explain the difference between the two funds. He quickly confessed that he didn’t know the makeup of the mutual funds. Instead, he relied solely on a financial model from his investment firm to run the portfolio. Needless to say, if you’re paying someone to invest your money and they can’t explain what they are doing, it may be time to move on.
A Little History
Have you ever wondered why people (like me) benchmark against the Standard & Poor’s 500? The S&P 500 is currently comprised of 505 of the largest companies to represent all industries in the United States. The reason it encompasses 505 companies and not 500, per its name, is because it includes two class shares for five companies, including Comcast, Discovery Communications, Google, News Corp. and Twenty-First Century Fox as of July 1, 2016.
One of the most remarkable things about the S&P 500 is that since 1928, it has compound annual growth rate (CAGR) of 8% average after inflation. This is a very good return in comparison to bonds, which have averaged around 5% and in comparison to real estate, which has returned just 0.2% after adjusted for inflation.
Many believe they can beat 8% and, like many investors, turn to mutual funds and hedge funds in hopes of beating the S&P 500. But the management fees incurred can often times can exceed 1%.
Mutual Funds
Let’s first look closely at mutual funds. Say that you invest in a mutual fund for $10,000. Before the mutual fund even invests your money, they essentially charge you $100 to manage your money. Now, the mutual fund company really has $9,900 to manage for you. In order for the mutual fund to beat the S&P 500 annual return of 8%, the mutual fund would actually need to make greater than 9.1% just to breakeven with the S&P 500. If the mutual fund continues to charge you 1% each year, over 30 years, your portfolio will be reduced by a minimum of 30%. That means the difference between a $300,000 portfolio and a $200,000 portfolio. As you can see, fees matter.
There are financial pundits out there who claim that fees don’t matter. Clearly, we can acknowledge that fees do matter because the mutual fund, by default, has a greater hurdle in order to beat the S&P 500. Overall, one’s portfolio can be reduced by these fees if it does not exceed the returns of the S&P 500.
On top of that, they counter this point by saying that on average, mutual funds typically return 12%.
Average vs. Annual Returns
Let me explain to you the difference between average and annual returns because there is a HUGE difference. Let’s say you invest $100 into Apple stock. If in the first year, Apple goes up by 50%, great, now you have $150. However, the next year, if Apple drops by 50%, sadly, you are left with $75. Based on an annual rate of return, you would have a 25% loss.
But if you follow their faulty reasoning, the average rate of return would be 0%, since Apple went up 50% the first year and down 50% the second year. This Mark Twain quote couldn’t be more fitting: “There are three kinds of lies: lies, damned lies, and statistics.” So, be very careful when someone spits rate of return figures at you. They may be sorely inaccurate.
Here’s another little secret that the financial industry won’t tell you; most mutual funds fail. The data shows that on average, 75% of actively managed mutual funds underperform the S&P 500 every year. For context, in 2014, 86% of actively managed funds failed to beat the market. In 2015, 66% of the actively managed funds failed to beat the market. So, what does the industry do when a mutual fund underperforms for a couple of years? They quietly close it down as if it never existed. That way they can remain marketable to individual investors in order to convince you to purchase one of their other mutual funds that seem to be beating the market.
Only 4 Mutual Funds
In 2015, Chuck Jaffe reported that over the last eight years, only four actively-managed mutual funds have beaten the S&P 500. This bears repeating. Only 4 active mutual funds beat the S&P 500 over 8 consecutive years. According to the most recent study there are over 9,000 mutual funds so the chances are 0.04% that you would have picked the correct mutual fund to beat the S&P 500 or 99.6% you would have chosen the wrong mutual fund. This is truly remarkable, so as you see, the odds are against an active mutual fund beating the S&P 500.
Buying the S&P 500
So you may be thinking, who buys the S&P 500?
Well have you ever heard of Warren Buffett? He’s the mega-rich investor that runs Berkshire Hathaway. He said regarding when he passes away,
“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Exchange Traded Funds (ETFs)
How can you buy the S&P 500? There are exchange traded funds (ETF) that can mimic the S&P 500.
Here are the three biggest ETFs that mirror the S&P 500:
- SPY (SPDR S&P 500 ETF)
- IVV (iShares Core S&P 500)
- VOO (Vanguard S&P 500).
Since each of these funds mirror the S&P 500, you may wonder which one to choose. Here are two ways to decide the right ETF for you:
- If you hold a Fidelity or Vanguard account, you can buy these funds (IVV for Fidelity and VOO for Vanguard) without paying a brokerage commission.
- If you don’t have a brokerage account with either one of these broker services, you can look at the expense fees for each ETF. According to Morningstar, SPY fees are currently 0.09%, IVV fees are currently 0.07% and VOO fees are currently 0.05%.
I recently opened up a Vanguard account in order to invest in VOO with commission-free trades and low expense fees.
While I may never beat the market, I won’t lose to the market either.
We recently broke up with our “financial advisor.” He was giving me the same crap over and over.
I feel so much more comfortable having the money in vanguard index funds now. Even have my wife’s Roth going!
Budget on a Stick recently posted…An Unexpected Gift
Thanks for sharing!!! Seems unfortunate that it feels like it’s more of a sales position which is unfortunate since it doesn’t always seem like people always get the best advice.
Good move. Most financial advisors want to get your assets under their management and then take a percentage of that annually. Unless they offer some type of special advice, there’s really no reason to pay that much. Especially when companies like Vanguard exist.
Thanks for sharing John!!! I definitely agree 🙂
Last Christmas my sister in law told me their financial advisor has never returned a penny on their investment in 3 years. She told me “we would have literally been better off had we just stuff that money into our pillowcase.” That to me means it didn’t even keep pace with inflation, which is quite sad in a bull market. I think we had a 20%+ growth from our portfolio last year.
She said she doesn’t know what to do now and she’s so used to losing money. I wanted to tell her to ditch their advisor but Jared kicked me under the table. Money is not discussed in the family because it’s informal. Uhh…OK. -_-
I hope more people read this Mr MSM. Maybe I’ll sneak it to her inbox ha!
Lily recently posted…TFG’s Income & Budget Breakdown (May 2017)
Feel free to send it her way 🙂 I’m to start that conversation even if it’s impolite. I wish someone did for me 🙂
Spot on! Unfortunately, 1pct expense ratio is even on the low end for active funds!
Daniel Palmer @ Pennies and Dollars recently posted…We’re Trying Swagbucks
Very good point Daniel!!! There are some very expensive mutual funds that charge more than that. Not to mention hedge funds which charge 2/20.
I’m so glad I discovered the personal finance blogosphere and the world of index funds before I was in too deep with a financial advisor. Thank you Vanguard and Jack Bogle!
Dr. Curious recently posted…Yes, I’ll Wrestle with You
I definitely agree I wasted too many years before I found Jack and Vanguard. Definitely happy I did.
We were lucky to learn about Index Fund investing early in our PF journey, which helped to steer us away from mutual fund and financial advisors. We are now die-hard SP500 and Vanguard fans!
Mrs. Adventure Rich recently posted…Spontaneous Adventure: June Beach Dinner
Thanks for sharing Mrs. Adventure Rich!!! I definitely wish I found them a lot earlier. Definitely wasted a lot of money and time over the years trying to beat the market.
Amazing stat that only 4 mutual funds have beat the S&P 500. That stock selecting monkey with a dartboard probably looks pretty good right now. 🙂
High Income Parents recently posted…Getting Ahead of the Pack with Health Saving Accounts
Hahahahahah….the monkey is probably as accurate at this point 🙂
When people ask me for advice, I recommend the ETF that you mentioned. However, for my own account, I manage my own fund where I write naked put options and covered calls to try and improve my returns. I can’t say that I beat the S&P 500 every year, but I beat it more that half of the time within the last nine years.
One of the reasons that I managed my own fund is to see how well I will perform as an investor.
Leo T. Ly @ isaved5k.com recently posted…Would You Borrow Money To Invest?
I’ve done the same with my portfolio over the last 15 years, while leaving my husband’s with a broker. Bad mistake. (Leaving my husband’s with a broker that is.)
Monica recently posted…How Much Money do I need to Retire? Part 1
Oh man…sorry to hear that Monica. Sounds like your husband has under performed yours by a lot. You’d think financial advice wouldn’t cost you 🙁
Thanks for sharing Leo!!! I definitely use to enjoy trying to beat the market when I was younger. Unfortunately as time became more sparse I decided to pull back and move towards passive index funds. Seemed easier but if I ever get more time I’d love to see how I’d do 🙂
Rob, I always appreciate your in-depth looks into the markets. Very educational. Thanks for sharing. What are your thoughts on the Acorns app?
I honestly don’t know as much about the app as I should. I believe that they charge 0.25% to manage your money over $5k but I have no idea how that compares to some of the other auto investing apps out there. have stuck with Vanguard since it’s commission free and the fees are so low 0.04%
The backstory on this sniffs of some Dave Ramsey dissatisfaction. 🙂 I have the same concerns with his mantras. Fees DO matter and 12% ISN’T a great number to use in forecasting.
“since 1928, it has compound annual growth rate (CAGR) of 8% average after inflation”
Yep! CAGR is what matters, and don’t forget inflation. Even a 6-7% “real return” CAGR would be enough to make most people’s financial dreams a reality… if they don’t wait too long to get started.
Great write-up Rob!
Brad – MaximizeYourMoney.com recently posted…How much do you need to save, from any age, to retire a millionaire?
I guess it’s pretty obvious how I feel about some financial guru’s advice 🙂 I definitely try to preach the CAGR point as much as possible. It’s important.
I’m a big fan of index funds but not limited to the s and p 500. The issue is with just one index you have a concentration in large caps. You need more exposure then that. Add to that it is a market cap index and certain stocks have a large impact on your holdings if you limit to one market.
FullTimeFinance recently posted…The impact of Universal Financial Independence?
Thanks for stopping by Full Time Finance!!! I can definitely see why you would want to add some additional exposure. I know a lot of people go with VTSAX which is the total market index to get more exposure as well.
It is so frustrating when financial advisors can’t explain their investments. I’m sure there are a lot of great financial advisors out there, but some of these guys are making them all look bad.
I started out investing in SPY before switching over to VTSAX. I liked the idea of going a bit broader than the S&P 500, which is why I went to a total market fund, and I preferred the mutual fund over the ETF because I can automatically invest a set amount of money and buy partial shares.
Matt @ Optimize Your Life recently posted…Platinum Cards and Status Symbols
Thanks for sharing Matt!!! I have definitely thought about investigating the VTSAX more. Looks like I have some weekend research to do.
Haha. Good for you helping your dad out. I had a similar conversation with my companies 401K adviser. Our fee’s are sky high and are returns are off by 2% from the market. He wrote me a dissertation about why those funds were in there and why we needed to stick with them. All I heard was yachts are expensive.
I wish improving your 401K fund selection was as easier but I am working on it.
Grant @ Life Prep Couple recently posted…Stop Mindlessly Going To College
You should speak to someone internal to the company rather than the advisor. I think you will get more traction that way. However, I don’t think you’ll get much traction because fees are fairly easy to reduce. The contract to manage a 401k is typically fixed length so when it expires, your company should shop around the plan. Fidelity & Vanguard are the two big players and compete largely on price.
There have been several cases where companies have been sued for not sufficiently monitoring their 401k agreement (i.e. fees are too high, conflicts of interest, kickbacks). Google “Schlichterized” or “Jerry Schlichter” or “Jerome Schlichter” for more information.
Thanks for sharing Dan. You are a wealth of great information!!!
Hahahahah…Yachts are expensive is a line I need to borrow. I lol’d on that one. That’s disappointing that you have such poor 401k fund choices. Seems like you should be able to share with HR how there are better plans available and cheaper.
Oooh interesting! Thanks for sharing this! I’m still wrapping my head around investments, but this was a great primer on the S&P (and why so many people love it!).
Mrs. Picky Pincher recently posted…What A Frugal Weekend! June 18
Thanks for stopping by Mrs. Picky Pincher!!! Glad this was hopeful 🙂
EnjoyING the blog MSM!!
I think the s&p is a great etf/index to own–cheap, braodley diversified, etc.
However I like the total stock market as well–maybe a little better than the s&p.
VTI and ITOT etfs are just as cheap if not cheaper.
Keep up the excellent posts!
DG
Thanks for sharing DG. I definitely need to check out VTI and ITOT. Thanks for the great reminder.
I never knew it held 505 instead of 500….something new I learned 🙂
Famous portfolio manager Bill Miller of Legg Mason Inc. beat the index 15 years in a row years back. As a result, inflows poured in into his managed mutual fund.
SMM recently posted…Simple Stock Comparison – KO & PEP
Thanks for stopping by SMM!!! I definitely agree there are some money managers that can beat the market. I just have trouble identifying them early on 🙂
I’ve never actually had an investment adviser. I’ve just learned lots of stuff from reading because it’s kind of a hobby for me.
Anyway almost all my money in Vanguard index funds, but none in the S&P500 fund. I have money in a diversified portfolio of Total Stock Market, US Large Value, US Medium Value, US Small Value, International Large, International Small, Total Bond Market, TIPS, International Bond Market, and REIT.
It’s a lot of funds 🙂 and I rebalance every year which is always a little nerve racking.
Mr. Freaky Frugal recently posted…Freaky Frugal or Stupid Frugal?
Thanks for sharing Mr. Freaky Frugal!!! Sounds like you have built the right asset allocation for you and your family. Asset allocation is so important 🙂
My father-in-laws advisor has him buying “non-traded RIETS” which are a high commission BS product. I am still trying to convince him to let me take the realm and put him in low cost mutual funds, but for now he keeps paying those fees.
It is amazing what stuff advisors will sell. Nice post and definitely keeping things simple is the way to go….
Dads Dollars Debts recently posted…Max out your tax advantaged retirement accounts
I do wonder with the newly minted fiduciary rules what will happen with those type of investments. Maybe you FIL should ask how these funds align with the advisors fiduciary responsibilities.
I’m a huge fan of indexing, but I also make significant stock investments on my own. The indexing guarantees a market return, but the individual stocks can be fun and do have some benefits (like better tax loss harvesting prospects) even if you’re fully on board that markets are efficient.
I do think investors should put their toe in the water just a little with individual stocks – not because they’ll beat the market, but because it’s a good experience and also because the index funds are made up of (wait for it…) individual stocks 🙂
Paul recently posted…The Key to Achieving Goals
Great point Paul!!! I definitely think when you have some skin in the game when it comes to individual stocks that you pay a little closer attention to understand how your portfolio works. Awesome point!!!
All my 401k contributions are placed into a fund that replicates the S&P 500. I love individual investing on my own, but when I don’t have the option to pick stocks and have to select from mutual funds, there is no sense going with a fund that attempts to beat the S&P. As you demonstrated, the odds of that happening are slim to none!
Bert
Thanks for sharing Bert!!! I definitely am so thankful that I have the ability to invest in a S&P 500 type fund. If I didn’t have that ability I would be in some serious trouble.
Great post. I once spoke to a financial adviser who said expenses don’t matter if the fund has good returns. He and I never spoke again after that. I too use a S&P 500 for my large cap allocation. It is perfect if you are into a keep it simple approach to investing.
dave recently posted…The Power of a Dual Income Couple
Thanks for sharing Dave!!! People that tout that fees don’t matter better show how they crush the market. Otherwise fees definitely matter.
You left out the best parts of the story. Did your father-in-law stick with his financial advisor? Did the advisor have a fiduciary responsibility? Did you report your conversation back to your father-in-law?
Hahaha…sorry to leave that out. My father in law decided that he wasn’t happy with the performance and decided to move into a combination of VOO, BRK-B and QQQ. He’s much happier with this asset allocation for him.
Personally, I invest in index funds. I have S&P500 and two other funds.
What I don’t invest in, I don’t invest in foreign markets and single stocks
Friendly Russian recently posted…A story about one financial mistake
Thanks for sharing Friendly Russian. I definitely don’t invest in foreign markets either. I don’t quite understand them so I pass on them as well 🙂
I think that going with an index fund it’s the best strategy if you don’t know too much about the stock market. In case you think you know a little more, then go with 90% index funds and 10% invest by yourself and check how it goes after a year and then decide if you want to try other things.
Alex @ Asset plus recently posted…How to manage money wisely
That’s definitely a great point Alex!!! Investing 10% in what you think is smart is definitely a low cost way to see if you are correct or not. Although I tend to avoid it now since only four professional money managers beat the market. I figure they have more resources than me so why bother. But then again I don’t have much confidence in my abilities 🙂
Great writeup… Indexing is our main investment approach.
I am working to get rid of our mutual fund portfolio… It is mentally harder than I Thought.
Right now, I rather go with options on ETFs and selected individual stock.
Amber tree recently posted…My experience – Fincon Masters – London
Thanks for sharing Amber Tree. I held on to a mutual fund way too long and I have no idea why I was so adverse to moving on. So I definitely understand.
Great post. That is why I love managing my own finances and investments. Minimal to no fees and you can make sure your money is in a good place for the long term. Low cost index funds to match the S&P500 are the way to go. Especially for the “set and forget” investors.
Dividend Daze recently posted…June 2017 Stock Poll
Thanks for sharing Dividend Daze!!! Set it and forget it are definitely the way to go for the majority of investors. The less tinkering the better.
Thanks for sharing. I like the S&P500 benchmarked index funds myself. Even better would be Wilshire 5000 benchmarked index funds because they include more midcap and the smallcap spaces as well for further diversification (total stock market index fund). But if you overlay any of the S&P500 and Wilshire5000 benchmarked funds or ETF’s, you’ll see that they’re pretty much identical.
Thanks for sharing Tim!!! I’ll definitely need to take a look at it. Interesting that they have similar benchmark returns. I’ll have to look into that.
Hi MSM,
Based on that I don’t blame him from walking away from the FA! I think for the majority of people an FA doesn’t make sense, however I think I am one of the very few people in the FI community who does have an FA.
This is for a variety of reasons:
1. He deals with far more than just my investment funds. He has multiple different “portfolios” based on tax efficiency across myself and my other half’s tax efficiency allowance but also looks after the tax view on how to efficiently invest, and in what
2. Diversification. I have access to some things that are not always as easily accessible as others – so beyond equities, bonds and cash and into “alternatives” (I won’t go into)
3. Mortgage broker. He also managed to sort out my mortgage (in fact a selection of 3 when we had a challenge moving home, but that is another story). He was also able to have all the discussions directly with the mortgage company to resolve the issue, so in effect all I did was tell him what I want, he came back with the options, and then we made our choice. We just had to sign a couple of papers, everything else was taken care of.
4. He Keeps me true 🙂 I know that sounds odd but I can bounce ideas or thoughts off him, and he can slap me down if I am being an idiot 🙂
5. Capital Preservation. He doesn’t necessarily outperform the benchmark every year (although to date over the last 5 years, even after fees he has). When the FTSE-100 in this case plummeted one year (lost more than 10%), my investments with him were down only a fraction (less than 1%). Preservation is important.
As an added bonus I keep track of his and my performance and each year we compare – he enjoys the challenge, and some years he beats me, sometimes I beat him.
The total cost for this? I pay 0.5% of all funds to him that I invest – so for every £100 I invest, he takes 50p. There are no trading costs, there are no ongoing fund charges etc. When I phoned up to discuss an investment idea, there was no cost.
For me it works, but my tax affairs and so forth are not the most straightforward, and so for I would say about 99% of people, it isn’t worth it!
Cheers,
FiL
FIREin’ London recently posted…T minus 8 years and counting….
Sorry – one clarification on ongoing fund charges. Obviously the funds I invest in do have a TER cost, but there is no cost for the platform holding them – hope that clears that up!
FIREin’ London recently posted…T minus 8 years and counting….
Thanks for the clarification.
Wow it sounds like you are truly getting value from your investment advisor and you are really happy with him. That’s awesome to here 🙂
Hi MSM,
Yes – I believe I do get the value, hence I have been with them for so long (7 years now). As I say, probably not worth it for most people, and if I had a far simpler life then I probably wouldnt use one, but it can be worth it for the right points!
Cheers
FiL
FIREin’ London recently posted…T minus 8 years and counting….
As someone who is still really intimidated by investing, the Vanguard S&P fund is the one that I wouldn’t hesitate to put money in. It makes sense to follow the advice of people like Buffett who have been successful over the long term.
I hope your FIL dumped that “friend” as an advisor.
My FIL definitely moved on and is incredibly happy with his low cost passive index funds 🙂
Huge fan of the S&P 500! I have a healthy portion of my investments in SPY. Thanks for breaking down that math. I love how you unveiled the truth stretching by the industry!
JT@JustMakingCents recently posted…Cool Math Lemonade Stand: Will It Really Teach Your Child About Making Money?
Glad you enjoyed it JT!!! I definitely am not a fan of some of the things that are said and done.
Love the distinction between annual and average rates of return. I must admit, I’m guilty of confusing the two terms at times myself – so thanks for the reminder!
I personally love the S&P500. I like the Vanguard VTI and VFINX funds myself. I just don’t have the time to become an expert in the market, so why not invest in something that only 4 mutual funds was able to beat over the last 8 years? Call me lazy, but index funds are definitely the way to go.
Matt Kuhn @ Profitable Matters recently posted…My Side Hustle Challenge
Thanks for stopping by Matt!! I definitely agree that passive index funds are the way to go for sure 🙂
Thanks for the info MSM. Most of my investments are in the S&P 500 and it’s the type of investment where you don’t have to worry about it on a daily basis, just check in on it a couple times a month.
Yeah you have to watch out for those high fees especially in 401Ks. Probably have to check the fund and see the percentage of fees they charge yearly. You could minimize it by picking funds with lower fees.
Thanks for sharing Kris!!! 401ks are one of the last beacons of the financial industry that stands. I can’t wait to see some of those get toppled so regular investors get better choices. Hopefully sooner rather than later.