According to the most recent DALBAR study, the average mutual fund investor underperformed the S&P 500 by 3.52% during the past 20 years.
The study stated the 20-year annualized return of the S&P 500 was 8.19%. However, the average return of the average equity mutual fund investor was only 4.67%.
At first glance, this doesn’t appear to be much of difference, but $100,000 invested 20 years ago would have resulted in the following:
- The S&P 500 – $482,772
- The Average Mutual Fund Investor – $249,140
- A difference of $233,632
It’s difficult to believe the average investor lags that far behind the index, but it is true. Often, the DALBAR study reports much higher discrepancies.
Why does the average investor perform so poorly?
There are numerous reasons, but today I want to teach you how to beat 90% of investors.
Let me clarify, the information that is about to follow won’t help you beat investment Gods like Warren Buffett, Peter Lynch, or Benjamin Graham. However, if you implement these steps, your investment returns will be better than 90% of the population.
4 Rules to Invest Better than 90% of Investors
1) Own Index Funds NOT Mutual Funds
Warren Buffet said, “A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”
When one of the best investors of all-time makes this statement, we should listen.
Let’s start with the difference between the two types of investments.
Mutual funds, for the most part, are actively managed funds; this means the company hires managers to buy and sell stocks in hopes of beating the indexes.
Unfortunately, these managers often do not beat the indexes. SPIVA (S&P Indices Versus Active), states that 91.91% of large-cap equity fund managers have underperformed the S&P 500 for the past five years.
On the other hand, an index fund is a passively managed portfolio. Instead of hiring expensive fund managers, they create portfolios to generate returns equal to the equivalent index.
If a company offers an S&P 500 fund, they try to own the 500 stocks in the index with the same proportions as they exist in the market.
The benefits of owning an index fund include:
- Lower fees
- Better/same returns than most actively managed mutual funds
- Typically, no commissions to buy one
- More tax efficient than mutual funds
To beat 90% of investors, start with owning index funds.
2. Keep Expenses Low
Forbes stated that the all-in cost for the average mutual fund is 3.17% a year.
These are high fees for any money manager to overcome. Just to beat the S&P 500 index over the past two decades, managers would have had to earn a return of 11.37%.
Additionally, the fees impact a portfolio negatively. If you were to invest in a mutual fund that beat the S&P by one percentage point before fees, you would still end up losing. After 30 years, you would have just 65% of what an index fund investor had in their portfolio.
Senator Peter Fitzgerald once said, “The mutual fund industry is now the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings.”
3. Stay Invested
Staying invested for the long-haul, 20 or 30 years, is essential to getting the most bang for your buck. There are two reasons to make sure you stay invested; 1) Compound interest 2) It’s impossible to time the market.
Albert Einstein brilliantly said, “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.”
Compound interest is when your interest earns interest, and this infographic from Bank Rate visualizes this powerful concept.
The second reason to stay invested (even through market downturns) is that you can’t time the market.
As Daniel Kahneman said, “the average investor’s return is significantly lower than market indices due primarily to market timing.”
What usually happens is investors take their money out of the market after it drops. So they take a 20% loss. Then they decide to invest after the market has recaptured its losses.
We don’t know when the market will go up or down; so make sure you stay invested.
4) Diversify/Asset Allocation
You have undoubtedly heard the phrase, don’t put all of your eggs in one basket; this is an important concept to understand for every investor.
We don’t want all of our money in one stock because if that company fails (Enron), then we lose everything.
Diversification is ensuring all of your money is not just in one place (i.e. Apple Stock). Asset allocation is investing in different asset classes (i.e. Large and small stocks).
Both of these concepts are important because it helps improve portfolios over the long-term.
MoneyGlare.com has an excellent article about the Importance of Investment Diversification. If you want to nerd out (and I suggest you do), then read the College Investor’s post on Why Portfolio Diversification isn’t Dead in the Least.
A truly diversified portfolio consists of assets allocated to the following:
- Large-cap stocks (growth & value)
- Small-cap stocks
- Emerging market stocks
- Bonds (short and long term)
- International bonds
- Real Estate
Each of these investments can be purchased in the form of index funds. Robo-advisors like Wealthfront and Betterment do this for you, so you don’t even have to think.
There are numerous reasons most people don’t outpace the S&P 500. Some people get too emotionally involved, others invest all their money in one stock, and some people simply never learn.
Beating 90% of investors is not hard. You can do it by following the four rules above.
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