AS EVERY CONSUMER knows, you generally get what you pay for. The more you pay for something, whether it’s a meal out, a holiday or a washing machine, the better you expect it to be in terms of quality. The Skoda Fabia or Dacia Sandero are both perfectly good cars, but there’s a reason why you can buy at least ten of those for a new Aston Martin Vantage.
But what if we told you that, with investing, the opposite is true? That the less you pay to an investment provider, the better your outcome is likely to be? Well, that’s exactly how it is.
As we’ve already explained, picking stocks that will outperform the stock market is extremely difficult. Why? Because the stock market is very efficient. Current share prices reflect all known information about a particular company and so how are you going to find novel, unknown information about a company that the rest of the market does not know as well? It’s very hard to do. The theory behind this is called the efficient market hypothesis (EMH).
Instead of trying to pick winning investments in individual companies, Ben and I recommend investing in index funds, or trackers, which hold every single company in a particular market. Instead of paying for an active fund manager to choose stocks for you, or instead of trying to choose individual company investments yourself, index investors choose to invest passively in the whole market. That market might be the FTSE 100 of the 100 biggest UK companies, the whole UK market of all UK companies, or indeed the whole global market of all companies listed on stock markets worldwide.
Now, you can argue the toss about just how efficient markets are, but it’s fair to say that they’re efficient enough to be very hard to beat. Studies have shown that, over the long term, only a tiny fraction of actively managed funds succeed in beating the market. And what’s more, those very few funds are almost impossible to identify in advance.
There is however a more fundamental reason for using passive funds over active ones – they’re much cheaper.
It was the late Jack Bogle who launched the first index fund available to ordinary investors, the Vanguard S&P 500 Index Fund, in the mid-1970s. Instead of EMH, Bogle liked to refer to CMH, the cost matters hypothesis:
The case for indexing isn’t based on the efficient market hypothesis. It’s based on the simple arithmetic of the cost matters hypothesis. In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.
Index funds are hard to beat because you get to keep more of the returns by paying lower fees than investors pay in actively managed funds. Not only are the expenses lower on these funds, thus offering you a larger percentage of the take-home return, but they trade less, meaning there are fewer transaction costs. This idea of the cheaper product being better is the exact opposite of most things you buy in other areas of your life, which is one of the reasons investing can be so counter-intuitive.
Investment research firm Morningstar performed a study that looked at all of the variables that predicted the future success or failure of a mutual fund in terms of its performance. The variable with the higher predictive power had nothing to do with the intelligence of the portfolio manager selecting the stocks or their ability to forecast the future or which university they attended. The variable with the most predictive power was cost. Looking across every asset class, Morningstar found the cheapest 20% of funds were three times more likely to succeed than the most expensive 20% of funds.
When it comes to investing, being cheap is a virtue.
If you based your investment decisions on nothing other than choosing the funds with the lowest costs, you would likely do better than 70–80% of all investors. All else equal, if you’re choosing a fund for your company pension or investment account, picking the one with the lowest cost is a good starting point. And if you’re picking a target-date fund, try to find the one that holds mostly index funds. Holding low-cost funds doesn’t guarantee that you’ll earn higher returns on your savings, but it does guarantee you’ll take home more on a net basis than the alternative, the majority of the time.
Compound interest can provide a tailwind over the long haul when it comes to growing your wealth, but fund fees can quietly counteract this advantage if you’re not careful.
So, whether you’re using a target-date fund or a robo-adviser, ensure that your investments are passively managed and low-cost. As a rule of thumb, you should only consider a fund with an annual management charge of less than 0.30%.
The cheapest investments tend to be exchange-traded funds, or ETFs. But beware: not all ETFs are passively managed. Do your research and read the small print before signing up.
And once you’ve built your portfolio and set up automatic monthly payments into your pension or investment account, here’s what we recommend you do: nothing. That’s right, the less you do, the less you think about it and the less you check your account balance, the better your returns are likely to be.
As the famous investor Benjamin Graham once wrote, “The investor’s chief problem – even his worst enemy – is likely to be himself.”
In the next chapter, we’re going to show you a simple and highly effective way to stop you meddling with your investments.