An important aspect of achieving financial independence at an early age is making your money work for you by making prudent investment decisions. For many people, this means investing in the stock market, but with no shortage of investment options, you have probably asked yourself what should I invest in?
As you ponder that question I want to make sure you are aware of an alarming hidden truth that exists in the investment world. When we think of professionals we think of people who spent years on their education, experience, and continuous improvement to be masters of their craft.
This reasonable reasoning leads many to the assumption that investment managers for mutual funds or hedge funds can consistently beat the market on a risk adjusted basis. This has been proven false by an overwhelming amount of data and evidence on historical fund performance.
Approximately 95% of money managers fail to beat their benchmark. That is truly astonishing. The entire mutual fund & hedge fund industry is built on a false premise!
It’s all built on the assumption that professional money managers can beat the stock market consistently over time. What’s even more damning about the 95% of money managers who underperform is that the 5% who do beat the market changes each year.
We can estimate that over a 10 year time horizon less than 1% of money managers beat the stock market. Remember the returns are further deteriorated by the exorbitant fees charged that is caused by churning (high trading volume). Why take the risk of trying to choose the needle in the haystack when the risk return on such a decision is so negatively imbalanced?
Index funds such as those offered by Vanguard give you the exact performance of the underlying index less a minuscule fee, which is usually .05%. The average Mutual Fund expense ratio is above 1%, but let’s compare two scenarios to understand the enormous impact of fees on your investment performance.
Beginning at the age of 25 two investors make $18,000 in annual contributions to their 401K and their employer contributes an additional $18,000. For simplicity purposes, the contribution amounts do not change and their annualized return over the next 25 years is 8%. The only difference is that Investor A chooses actively managed Mutual Funds, with a cumulative expense ratio of 1%, while the Investor B uses index funds with an expense ratio of .05%. The effect of choosing the actively managed mutual funds is an ending portfolio value that is approximately 10% lower than the portfolio that utilized index funds.
Knowing the statistics of actively managed mutual funds and still choosing to invest in them is an act of self deception. There are no data points you can point to that would give you a reasonable chance to choose money managers who outperform the stock market on a consistent basis.
The only group that benefits from actively managed mutual funds are the money managers themselves and the firms they work for. It is a scam perpetuated by ignorance and unscrupulous incentives.
Have you ever spoken with a financial advisor? I have and my experience was laughable. I met a financial advisor through my personal network and being the curious type I agreed to a meeting to see what he could offer me. I explained my financial situation and my goal of financial independence in my early thirties. He was taken back that such a young person would even set such a goal, but he still made the same boilerplate actively managed mutual fund recommendations.
Upton Sinclair once said:
“It is difficult to get a man to understand something when his salary depends on him not understanding it.”
This comes from an understanding of human nature and psychology and it applied perfectly to the financial advisor who was trying to push mutual funds on me because they were in his financial interest. I tried explaining the facts, “95% of money managers don’t beat their benchmark, the outperforming managers change each year, and they charge 20x more in fees on average each year.”
If he accepted the facts he’d probably need to find a new job. This is why understanding the incentives and subtext of financial advisors is so critical to your long term financial health. Since the same incentives and assumptions are being peddled by all financial advisors who earn a commission when you invest in actively managed mutual funds, it follows that everyone must arm themselves with the truth or risk being swindled by financial advisors whose job depends on client ignorance.
That may be a hard pill to swallow, but the entire industry is built on deception, illusions, and ignorance and as someone who is striving to reach financial independence at a youthful age you must steer clear of this minefield.