In What is Money Management Part 1, we look at what it is, disclose our variant perception, and discuss the average professional money manager’s performance. Here in Part 2 of this series, we look at how the active individual investor and you the passive money manager compare in the same thought experiment. There is a way to achieve a much better outcome, and it might surprise you. And, it is supported by the best in the money management business.
Let’s get to it.
The Active Individual Investor Approach
Some choose to select mutual funds or individual company stocks themselves under a belief they can achieve the market average and perhaps outperform the market.
However, a look at the active individual investor’s *average* performance record shows the individual investor also underperforms the market.
DALBAR’s Quantitative Analysis of Investor Behavior [QAIB] study shows the effect of individual investor decisions on returns. Over 30 years, when the S&P 500 annualized return was 10.16%, the equity mutual fund investor’s annualized return was 3.98%. That is 6.18% below the S&P 500.
They found the underperformance was as a result of investor behavior more than of the underlying fund’s performance. They attribute the underperformance to poor decisions, market timing, and a short term investment period of fewer than four years.
The Fidelity Magellan Fund Similar Findings
Fidelity’s fund manager Peter Lynch ran the highly successful Fidelity Magellan fund from 1977-1990 and earned an outstanding 29% average annual return.
In a subsequent study by Fidelity, they found the average investor during that period in the Magellan fund lost money. What happened?
According to Fidelity, individual investors tended to let their emotions rule rather than acceptable investing practices. They were greedy when the market was rising and bought fund shares paying the higher share prices. However, the market was falling, they were fearful and sold fund shares at lower prices.
Buy high and sell low is not the right formula for investment success and discussed further in [The Rational Investor].
Applying the DALBAR’s 6.2% underperformance for the individual investor, the result is the same as the average money manager. The outcome is $713,000 instead of the $5.2 million expected over forty-five years.
No wonder people struggle to find financial security during retirement.
You the Passive Money Manager
This passive do-it-yourself method is less work and yields better results. And, it amounts to automatically depositing the $500 per month into a low-cost index fund for forty-five years and forget about it other than periodic reviews.
What is the estimated outcome for you the passive money manager using this approach? Assume a 0.3% annual index fund expense over the forty-five years. The outcome is a much more acceptable $4.7 million at the forty-five-year end of our thought experiment.
Compare the potential $4.7 million with you the passive money manager to the $713,00o of the professional money manager in Part 1. And, consider the difference of $4.0 million as your reward over the 45 year period. In hindsight, that means you averaged about $89,000 per year: not a bad part-time job, was it?
The assumed expense of 0.3% is high compared to what’s available, so the outcome would likely be higher. The Vanguard S&P 500 index fund (VOO), for example, has a 0.03% expense, and that would yield $5.2 million, just $55,000 below the assumed long term market’s average.
What are Index Funds?
Index funds seek to track the performance of the market indexes like the S&P 500. The fund holds the same stock and proportions as the S&P 500 index to match its’ performance.
Consequently, index funds offer instant diversification, remove the analysis (or guesswork) out of money management, and charge low fees.
Industry legend John (Jack) Bogle created the low-cost index funds and made them famous. He recognized the problems with the approaches above and founded the Vanguard Funds to solve them.
Bogle created the index fund in 1975, and it snowballed. They are widely used today by countless individuals investing in their future. I like to think Jack Bogle has brought the investing aspect of money management back to the home where it belongs.
“Investing is not nearly as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.”
– Jack Bogle
Bogle criticized fees investors had to pay for mutual funds. He said, “The miracle of compounding returns has been overwhelmed by the tyranny of compounding costs.”
Jack Bogle authored several books, including one of my favorites: “The Little Book of Common Sense Investing.” It reflects his easy to understand, a common-sense approach to investing, and timeless words of wisdom.
“Rely on the ordinary virtues that intelligent, balanced human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance.”
– Jack Bogle
In a world where financial institutions make investing increasingly complex, Bogle’s investment approach is straightforward and attracted a vast and growing following.
Warren Buffett’s Testimony for Jack Bogle
In 2017, legendary investor Warren Buffett, the billionaire chairman and CEO of Berkshire Hathaway, wrote in his widely-read annual letter to Berkshire shareholders:
“If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value. In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and me.”
Now that’s a vote of confidence in you the passive money manager from two of the wisest in the investing world!
What is Warren Buffett View of Index Funds?
Warren Buffett is one of the most successful investors who ever lived, so he speaks and investing people listen. So he must know something about successful investing. Buffett emphasizes putting money into index funds, time, and time again, as a reliable way for most investors to take advantage of market gains while hedging against risk. With this in mind, he has directed his billions there, too, when he is no longer an active investor.
Buffett recommends index funds as a way to boost retirement savings. “Consistently buy an S&P 500 low-cost index fund; I think it’s the thing that makes the most sense practically all of the time.”
“The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.” – Warren Buffett
You the Passive Money Manager Summary:
- Money management is making the most of what you earn, borrow, save, and invest.
- It starts at home with common sense, and some financial literacy to assure your fair share of economic prosperity.
- The thought experiment compares the likely outcomes of three different investing approaches:
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- The Money Manager $713,000
- The Active Individual Investor $713,000
- You the Passive Money Manager $4,700,000
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- You are your best money manager; no one cares more about your money than you do, and no one’s interests are more aligned to yours than your own.
- There are outstanding individual active investors, actively managed funds, and money managers. The challenge is to find them.
- Whatever path you choose, there is a learning curve, the key is to get started.
- Successful investing is not complicated. It is doing a few things right and avoiding serious mistakes.
- There is nothing complicated about buying index funds and holding them.
- Save more, think long-term, and allow compound returns to accelerate your wealth creation.
Don’t underestimate yourself. You know enough about money management to start. Take this information and make an informed decision and choose an approach that fits your comfort level.
Every choice we make is one step on the path towards a future that is yet to be written. Whatever you decided for this year and beyond, take responsibility, unleash the power of compounding, to reach your full potential.
In the next post on money management, we’ll discuss options for the more enterprising investor.
Full Disclosure
Early in my career, I chose to learn and become an active individual investor. It took time, I made a lot of mistakes and learned from them.
The time spent and lessons learned was an investment in myself. It eventually paid off. I chose to leave a good career, continued as an active independent investor, and reserved precious time to enjoy the rest of what life had to offer.
If this post was helpful, please share it with those that may wonder; what is money management?
Thank you for reading!
What is Money Management? Part 1