Friday, March 26, 2010

Simple Math to Compounded Interest...



The book of the week was The Little Book of Common Sense Investing by John C. Bogle. Bogle is the founder and former CEO of the Vanguard Mutual Fund Group. He is the inventor of the very first index fund, so the information in the book encouraging index investing is biased. However, Bogle backs up every opinion with facts and basic arithmetic. The end of each chapter has a box that reinforces the ideas of the chapter by giving quotes or writings from some of the world's most renowned financial experts including: Benjamin Graham, Peter Lynch, William Bernstein, Warren Buffet and many more.

If you are familiar with my investing philosophies you already know that I am a big fan of Index Funds. This book illustrates even more reasons to avoid financial advisors and, definitely, actively managed mutual funds. The costs associated with using these mediums of investing is way too high and has very little to zero benefit.

The reason someone would sign up to pay more money for an actively managed mutual fund is the promise of higher returns. But this is an empty promise for 90% of mutual funds. The majority of actively managed mutual funds cannot perform better than the market average in the long-term. However, if, hypothetically, you did choose a mutual fund that outperforms the market average, the most you will beat the market by is about 1.5% (and that is the high).  But since you chose a mutual fund you will have higher expense fees by about 1.3%... so you'll think that you still made a good decision because you made .2% more than the market average. This is also FALSE. Your mutual fund also comes with transaction costs that are about .7% higher than a index fund and tax inefficiencies that equate to about 1% higher. So the mutual fund that you chose, that had only a 10% chance of being higher an index fund, gave you 1.5% less on your money than an index fund would have given you.

To put it in even simpler terms... If you invested $10,000 and let it accrue interest for 20 years and you managed to pick that diamond-in-the-rough mutual fund with higher returns, you would still only make $44,087. Opposed to an index fund during the same amount of time that would grow to $58,137... That amounts to a disadvantage of $14,050. That difference could be a down-payment on a house!

Bogle is big on using simple arithmetic to determine what investment is best. As you can see from the numbers, it doesn't take a rocket scientist to analyze the numbers. And if you prefer to let a computer run the numbers go here http://www.moneychimp.com/articles/index_funds/expenses.htm

One thing I hadn't thought of before reading this book relates to tax inefficiencies. When you have an actively managed fund, you'll have an "expert" that thinks that they can outperform the market. So that person buys and sells when they think the time is right, but it's your money they are using the whole time. That means that if they do get you the market average at the end of the year, you'll be charged for the gains you received every time they sold. And if there is anything I disdain, it's TAXES. You've been happy all year long because you think you did well with your investments and you may have even sent your Money Manager a Christmas card and then you ring in the new year with a 1099B... more gains to pay taxes on!

If you are serious about investing in Index Funds go to Vanguard  and use this diversification:

35% VTSMX- This is a domestic stock fund
35% VGTSX- This is a international stock fund
30% VBMFX- This is a bond fund

It's a rocky climate right now for investing and I am not positive what is going to happen. I have my predictions (I lean toward more international index investing than I normally would right now), but for the time being I would like people to be able to make good decision when comparing actively managed mutual funds and index funds. If you have any questions on the book don't hesitate to ask. I would be more than happy to help anyone that wants it.

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