COLUMN: Invest? Yes. But maybe not with a broker

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COLUMN: Invest? Yes. But maybe not with a broker

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Summer is over and it’s time to go back to school. Hopefully, you did something with your summer, and didn’t just hibernate in your room watching Game of Thrones all day (especially since Westworld is definitely better). If you did manage to get out of the house, you may have earned some money from a summer job, and if it hasn’t all been spent on food, clothes, and shoes, you might want to invest some. Investing is a great way to make money without the hassle of actually doing anything.

There are three options: invest the money yourself, invest it in an index fund, or invest it in a managed fund. Obviously, since you are not a stock market expert, you should invest in a fund instead of investing by yourself (and we’ll later see that even if you are an expert, you still shouldn’t invest by yourself).

To choose between a managed fund and an index fund, you need to understand their differences. A managed fund is exactly what is sounds like: you pay a stock market expert — a manager — to invest your money in companies that he or she thinks will do well. An index fund, on the other hand, simply buys all the stocks in a given stock market index, such as the Dow Jones Industrial Average, the S&P 500, or even niche indexes like silver mining stocks.

Now you might assume that you should choose the managed funds. After all, these funds are managed by professional investors; they should know what they are doing, right?  However, when you look at the numbers, you’ll find index funds consistently outperform managed funds. According to a study by S&P Dow Jones Indices, over a 10-year period the vast majority of index funds outperformed all three main types of managed funds, known as large-cap, mid-cap and small-cap. The index funds outperformed 82.14 percent of large-cap managed funds, 87.61 percent of mid-cap managed funds, and 88.42 percent of small-cap managed funds.

Given this surprising result, there is an obvious question: why does this happen?

One reason is actually that the managed funds have managers. These managers command high salaries, and the money to pay those salaries is taken out of the money you invest.

Because they don’t have managers, index funds can charge fees less of than 0.2% for investing, compared to managed funds’ 1% or more. This means that in order to outperform index funds, managed funds don’t just have to beat the market, they have to beat the market by enough to cover their extra fees. And most managed funds simply can’t do that.

The second reason is much simpler: you can’t beat the stock market. This can be explained by the Efficient Market Hypothesis, which states that stock prices reflect all available information and trade at their true price. That means that it is impossible for a manager to buy undervalued stock or sell stock at a higher price than its actual worth, because all stocks buy and sell at their true price. This isn’t to say that managed funds won’t sometimes give huge returns, but when they do it will be due to luck, not skill. People like to think that managing stocks is full of skill and intelligence, but in reality, it’s more like being a professional gambler.

So, if managed funds consistently cannot outperform index funds, and usually perform worse, why do they still exist? The answer is twofold: People feel more comfortable having a professional manage their portfolio, and investing companies encourage their clients to use managed funds so they can charge higher fees and make more money.

In other words, even though managed funds are not in an investor’s best interest, they are in an investment company’s best interest. So companies they have an incentive to get people to sign up for them, despite the fact that their customers will be losing money.

Reading this column won’t make you an expert in investing and making money, but luckily, you don’t need to be one to turn your hard earned summer money into extra cash. Simply invest in an index fund and your returns will be better, without the added difficulty of having to go to business school.

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