FINALLY we are at the good bit – our choices within our besties investment class: equities 🙂 If you haven’t read parts 1 to 5 of this series and are feeling a little lost/over-whelmed then please check them out in The Numbers section, dear Reader.
Because everyone shouts the benefits of passive investing (index tracking funds) that’s where I started in my investing-self-education quest. I wrote “passive investing” on a piece of paper and then started reading around it, adding to my piece of paper as I learnt. I wanted to understand how passive investing fitted into the investing world and what my alternative options were.
Basically I knew that I would only be comfortable with passive investing if I knew that it was better than any other investing option… which required learning about what all my options were. I learnt repeatedly (see Part 3, Part 4 and Part 5) that equities/stocks are my best option, which meant that my piece of paper stayed focused on my options within equities. This is what my piece of paper about equities eventually looked like (although I have made it slightly prettier for you, dear Reader!):
I think it’s safe to say that investing using my own brain to choose each individual stock is a terrible idea at this stage. Maybe one day when I am big, have learnt exponentially more and feel financially secure enough to risk possibly losing some money… But that day is not today. And if (risk-adverse) Husband has anything to say about it, it will probably never be the day!
Option 2 is to go with a fund manager/broker/bank/insurance company/financial advisor, which initially I was very open to. But the more I read the more these two facts stayed with me:
- Experts (people or companies with fancy qualifications and experience) are expensive. And this expense cannot help but compoundly eat away at my investment. It’s not just a fee per year. There are a whole bunch of other costs usually involved too. And all those costs and fees eat away at interest that would have earned me compound interest, which would have in turn earned me more compound interest etc. Forbes provides a beautiful example on the impact fees can have on an investment:
“Assume an all in cost for your fund purchase is 1.5% per year and we pick an investment horizon of ten, fifteen and twenty years. Next let’s postulate that before fees this fund has a total return of nine percent per annum. Now let’s compare returns before and after fees….9 percent vs. 7.5 percent. For ten years at 9 percent a $1,000 investment becomes $2,370 but when the expenses are deducted you are return diminishes to $2,060. As more time passes the effects of compounding further exacerbate the differences. For fifteen years 9 percent returns $3,640 while the 7.5 percent investment yields only $2,950. 20 year totals are $5,600 versus $4,250. Unless you have a super manager these are long odds to overcome indeed.”
Which leads me to the next point about option 2:
- Actively managed funds very rarely beat the market. Passive funds or index tracking funds are funds that try as closely as possible to copy the market. In other words, if actively managed funds rarely beat the market it means that they rarely do better than passive funds (our option 3). The odds are simply too stacked against active fund managers to consistently beat the market. As Steven Nathan in his honest and easy to understand article states: “80% of active funds underperform a low cost index over periods of five years and longer”. WHAT?! And “over the long run (ten years plus), the probability [of an actively managed fund beating a passively managed fund] is well less than 20%”. So while it is possible that a fund manager could beat the market (index), it is not probable over the long-term. And since I want to give myself the highest probable chance of success, that leaves me with one resounding option for investing in equities:
Option 3: PASSIVE INVESTING/INDEX TRACKING FUNDS
But the wonder and beauty that is passive investing or index tracking funds deserves an entire post all to itself…. So till next time, dear Reader! 🙂