2010’s will go down in history as one of the best decades for investors. With a booming stock market and new easy to use investing platforms, it has become cheaper and easier for everyday people to invest in the stock market. The past 10 years have been the best ever for stock market returns.
Investors who stayed the course through the market’s ups and downs were rewarded. If at the start of the decade, you had invested $500 in exchange-traded funds (ETFs) that track the major market benchmarks, that amount would have tripled to a value of at least $1,500 by December 31, 2019.
The 2010-2019 period coincided with the longest bull market in history, which began in March 2009. Through the end of 2019, the S&P 500 rose more than 370% during the current bull market run. Taking into account reinvested dividends, the total returns swelled to more than 490%.
Capping off the decade, the S&P 500 rose almost 29% in 2019 for the 10th best year of returns in history. That was just behind 2013′s nearly 30% gain.The S&P 500 notched its second-largest gain over the past 20 years in 2019.
As an investor how do you make sense of the markets ?
How long will the bull run continue. What if a crash is looming round the corner. Should you encash the gains and hold on to cash? Where should you invest?
There are scores of experts and investment funds that will tell you how their funds will beat the stock market returns. You’ll be told how to win by “shifting among sub-sectors,” by “staying in touch with the primary trend,” by “picking hidden gems,” by “owning an environment conscious portfolio,” Buying options and selling puts, “adopt a contrarian investment style” and many such creative options.Yada Yada..you get the message.
While some of these strategies may well work, past data shows that most won’t.
What does the past data show ?
Very few investment funds come anywhere close to consistently beating the returns that the well diversified stock market index such as S&P 500 delivers. Over the last ten years, only ten of the 10,000 actively managed mutual funds have managed to beat the S&P 500 index consistently .
Majority of the mutual funds have underperformed as per data from S&P below. With those odds, we can only wonder why investors don’t simply hold the stock market index fund and eliminate the overwhelming likelihood of earning less, perhaps much less than the broad market returns.
But what is an index fund?
An index fund is a mutual fund or ETF that is designed to track a specific index of stocks, bonds or other investments. Dow Jones Industrial Average or Standard and Poor 500 are examples of Index. The S&P 500 index fund for example would invest in all the 500 companies and hence closely mirror the performance of the broad market.
Why invest in an index fund?
Index funds comprise of all the companies comprising the specific index and hence there is little effort from fund managers to manage the funds. These funds are also called passive funds as the managers do not have to actively buy and sell stock.
Hence the cost to the investor in these funds is the lowest and can be in the 0.05 to 0.07% range, while actively managed funds are generally in the 1-2% range. Economists suggest that it is not possible to beat the market consistently and hence according to the “efficient market hypothesis” it may be efficient to simply buy all the stocks comprising the market – which is what an index fund does.
Index fund is a cost effective way to acquire hundreds of leading American companies while saving on hundreds or thousands of dollars in brokerage fee.
Why is it so difficult to beat the market’s returns?
Because market returns are impacted by the costs of investing. In the search for the Holy Grail of superior returns, retail investors incur heavy costs — fund management fees, operating costs, brokerage commissions, sales loads, transaction costs, fees to advisers, out-of-pocket charges, and so on. Performance varies, but costs roll on forever.
Stock funds incur substantial management costs. If a mutual fund charges an annual expense ratio of 1.5 percent per year, and carries a 5 percent sales charge (if held for ten years, .5 percent per year), for a total of 2 percent per year.The cost of the fund’s portfolio turnover, can add another .5 percent to 1.5 percent to those direct costs. So total direct costs can run about 2 to 3 percent of the assets each year.
Now, perhaps mutual fund managers are so smart that they will deliver significant returns so as to offset those additional costs. The average manager, it turns out is well, average. Thus mutual funds as a group should earn the market’s return—before costs. But given those costs of 2 or more percent per year, we should expect them to lag the market’s return by that amount.
And they do! For the tenth consecutive year the majority of large cap funds lagged the S&P 500 last year. After 10 years 85% of the large cap funds underperformed the S&P 500 and after 15 years, nearly 92% are trailing the index. Don’t be surprised. That’s just what we should expect.
When the management costs are compounded, the gap reaches stunning proportions. The mutual fund system puts up zero percent of the capital and assumes zero percent of the risk, but collects a bulk of the returns. Almost half of the profit is siphoned away by those who had everything to gain, and nothing to lose.
So when we look at the performance of the average stock fund , and compound those returns, we see that a yawning gap between the return earned by the average fund and the return of stock market itself.
$100,000 invested in the stock market for two and half decades would have grown by $330,000 . However the same amount will grow by only $160,000 after accounting for 2% fees . Together, the cost penalty and the timing penalty and the selection penalty caused the fund investor to earn only around 50 percent of the profit that could have been earned by simply buying and holding the stock market itself.
So what should an investor do?
Ask the Experts . Legendary investor Warren Buffett says that a low cost index fund such as the S&P 500 index fund is the best investment most Americans can make. Buffet feels that investment in a S&P 500 index fund is a bet on American business and historically this has been a good investment. The S&P 500 index fund has delivered annualised returns of 10% since inception.
And since S&P 500 index funds have minimal fees, you the investor get to keep most of the returns.
Ask Jack Meyer, the remarkably successful investor who tripled the Harvard Endowment Fund from $8 billion to $27 billion. Here’s what he had to say:
“Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value.
“Can private investors draw any lessons from what Harvard does?” Meyer’s advice: “Yes.” First, get diversified. Come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low.’ That means avoiding the most hyped but expensive funds, in favor of low-cost index funds. And finally, invest for the long term.”
Successful investing is pretty simple. Just do a few simple things right, and avoid making stupid mistakes.
First, Don’t be the active investor – investing on impulse, buying on tips, selling on rumours and letting your emotions overwhelm your reason.
In investing, realize that you will gain significantly by actually not doing anything. Yes! be the passive investor.
Second, Own American business . . . not one company or industry, but a broadly diversified portfolio of lots of companies and industries. Buy such a portfolio, seldom sell.
Third, Stay the course. Invest for the long term—decades, even a lifetime—and start as soon as you can. No one knows what stocks will do tomorrow, or even what they’ll do over the next few decades, but over the long pull, the dividends and earnings growth of American business will be reflected in rising stock prices.
For more stories on personal finance read Investment tips by Vanguard founder – Jack Bogle