Why shouldn’t you trust your money to a broker or agent who claims to be able to successfully pick winning stocks or funds?
Let’s say you have $100,000 to invest. An investment manager – a mutual fund manager, stock broker or private account manager – will offer, for a fee, to manage your money. That is called active professional investment management. The typical fee for this management is 1 percent of the account’s balance per year, but this rate can vary widely and often runs up to 1.5 to 2 percent. Mutual fund managers typically take their fee daily, while private money managers usually bill quarterly.
Why would you agree to pay? What are you paying for? Going down this path requires that you pay, without regard to results. On a $100,000 balance, at 1 percent, you’re agreeing to pay $1,000 per year, no matter what happens with your investment. The manager will say it’s for “professional management,” but there is no universal definition of professional management. The fact is that you’re agreeing to pay for something without any real knowledge of what you’ll get in return. You’re making an expensive bet, and like all bets, you shouldn’t make it unless you know its odds.
You have the option of investing in the market itself through index funds, like the funds offered in your Thrift Savings Plan account. My aggressive advocacy for the TSP over past 15 or so years is largely based upon its use of index funds. Index funds give you lowest-cost access to the investment risk and return of the entire investment market, or any submarket you might want, in a single security.
In the TSP, you can invest in the stock and bond markets, easily and almost for free. If the S&P 500 index of stocks goes up by 10 percent next year, your C Fund shares will increase in value by that same 10 percent, less the tiny 0.05 percent cost they bear. You’ll realize a 9.95 percent return.
If, instead, you invest in that same market and pay 1 percent in management fees, your realized return will drop to 9 percent. The extra 0.95 percent fee you pay for active investment management — stock picking and timing — becomes a hurdle that the manager must overcome just to break even with the C Fund. You will lose money by paying for active investment management, unless the manager is successful enough to make it over the cost hurdle.
Charles D. Ellis, a leading institutional investing consultant and author of “Winning the Loser’s Game,” researched the track records of mutual fund managers and found that 60 percent failed to clear the hurdle in any given year, 70 percent failed over 10 years, and 80 percent failed over 20 years.
Why is this? Why can’t the best minds in the investing world, with the best resources and access to information and analysis, reliably beat the market? Investing is a zero-sum game. Take the S&P 500 index tracked by the C Fund as an example. That market for the stocks of 500 leading U.S.-based corporations will produce some return over the coming 12 months. You can own nearly all of this return by investing in the C Fund.
And, like a poker game, every dollar made by one investor is a dollar taken from another. The investment markets are a competitive game for profits that is dominated by professional institutional investment managers. For any of these managers to consistently win the game, year after year, they would have to corner the market on some special skill or resource. They would need to be, in effect, the best player in the game.
Over 20 years, any professional manager will win some years and lose some. In the end, the wins and losses will tend to even out, and a good manager’s performance will likely wind up matching the market’s average, before costs and fees. After costs and fees, all portfolios are more likely to lag the market than to beat it, or even match it. The expected return for any portfolio, managed or index, is the market’s return for the period, minus the costs and fees. So, the smart bet is on the investment portfolio with the lowest cost, and on this measure, the TSP can’t be beaten.