According to Standard and Poor’s (S&P), nearly 89% of active mutual fund managers underperformed their benchmarks over five years, and 82% did the same over the last decade ending in 2014. When reading statistics like these, why would any investor consider an investment strategy outside of passive index investing? In other words, why not just use mutual funds that mimic the index that also happen to charge a low internal fee? After all, “if you can’t beat them, join them,” as they say. There are few reasons to be unhappy as a passive investor when stock markets are rising, but what happens when stock markets are falling? Remember, passive index investing is like a ball floating on the ocean going wherever the tide takes it. Before embracing passive index investing you might want to consider some of the invisible costs which include: (1) the Relative Cost, (2) the Time Cost; and (3) the Opportunity Cost.
The Relative Cost
I recently met a gentleman who uses a well-known mutual fund family for all of his investments. The primary reason for using such a strategy is the “low cost” of the index mutual funds. But I asked him if he ever compared the internal cost of the investment in relation to the gain or loss during different stock cycles?
For instance, if he had originally invested $100,000 in a specific US stock market index fund, the annual expense would be 0.15%, or $150 per year. Seems cheap, right? But is it cheap relative to the result from being invested from the peak of the market in 2000 until the bottom in 2003? The result from such a passive indexing strategy would have been a loss of more than 48%, or a decline in dollar terms of more than $52,000 on a $100,000 initial investment. Would you consider that a “low-cost” investment when considered in relative terms?
The Time Cost
Have you ever heard the comment “the market always comes back?” Throughout history, that statement tends to bear true, but not always. Consider a passive index investor who bought into the Japanese stock market near the peak in 1989. At the time, the Nikkei Index was above 30,000 on its way towards 39,000. But fast forward to today, and it’s slightly above 20,500. After 26 years, a passive index investor is still waiting to get his or her original investment back. Could you afford to wait for over 26 years to get your original investment back if you made your initial investment at the wrong time?
The Opportunity Cost
The third cost, also related to the time cost, is the opportunity cost. Specifically, what an investor could have done with his or her money to be better off as an alternative to being passively invested in the stock market. For this reason, many investors “diversify” into other investment categories. Whether using certificates of deposit (CD’s), bonds of various types, gold, real estate, collectibles, or other investments, diversification can help investors put some of their money in areas that are rising in an attempt to ensure they don’t have all of their money in one area that is declining.
But can too much diversification be a bad thing? I believe the answer is yes. I believe this investment approach may diminish in future years as investors become wiser and more knowledgeable. I believe they will actively seek out strategies that focus on allocating more money towards investments that appear to be in positive trends while learning how to avoid allocating money towards investments that appear to be in negative trends just for the sake of “diversification.”
Whether you are an investor currently using a passive indexing strategy or one who is considering it, I hope you have a better understanding of some of the unseen costs and how they may negatively impact your long-term financial success. But before concluding this article, I have to say one thing I have always found curious. Besides statistics, many proponents of passive index investing say it is because no one can successfully “time” the market? But isn’t it ironic that one of the prime factors for why one passive investor is successful compared to another is due solely to the “timing” of when each makes their initial investment?
Jeffrey D. LINK
Disclosure:
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The DJIA was invented by Charles Dow back in 1896. It is not available for direct investment. The Nikkei 225, more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average is a stock market index for the Tokyo Stock Exchange (TSE).
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IMPORTANT DISCLOSURE NOTE: At the time this blog entry was published, Mr. Link was an Investment Adviser Representative with Guardian Capital Advisors, LLC (GCA, LLC). In December, 2015, GCA merged with Gordon Asset Management, LLC (GAM) a registered investment adviser, at which time Mr. Link’s registration as an Investment Adviser Representative was transferred to GAM. More information about GAM, including its investment strategies and objectives, can be obtained by visiting www.WealthQB.com, or in its Form ADV Part 2, which is available, at no charge, upon request, by calling (866) 216-1920.
