I don’t think mutual funds are the best way to invest your money for various reasons (including the risk involved and the fact that you can make higher returns with investments like real estate).  However, if you do feel compelled to invest in mutual funds, my advice is very simple: buy an index fund.

John Bogle (of the Vanguard Group) provides probably the best facts and analysis about mutual funds in his book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.

Index funds do not attempt to beat the returns of the stock market.  Instead, an index fund attempts to mirror a particular index (such as the S&P 500 index) as closely as it can by buying each of that index’s stocks in amounts equal to the proportions within the index itself.  Thus, an S&P 500 index fund buys each of the 500 stocks in that index in amounts proportional to the S&P 500 index. 

Index funds are, flat out, better investment vehicles than regular mutual funds for the following reasons:

1) In the long run, index funds will always beat the average mutual fund.  72% of actively-managed large-cap mutual funds fail to beat the stock market over the past five years.  This is partly a function of an index fund’s lower expenses (see below).  However, because an index matches the stock market (rather than try to beat it), it performs better than the average mutual fund that attempts (and often fails) to beat the market.

2) Index funds have much smaller expenses and fees than mutual funds.  It simply costs less to run an index fund because the stocks in an index are a known quantity.  Thus, there is no need to pay for stock analysts to pick the stocks to be held in the fund.   This translates into a lower expense ratio for index funds.  The expense ratio of an index fund can be as low as 0.15% for large company indexes.  (During the 1990s, the expense ratio for the Vanguard S&P 500 index fund was 0.19%.)  Index funds that match other indexes (such as emerging market indexes) have expense ratios around 0.9%.  By contrast, the expense ratio for the average large cap actively-managed mutual fund is 1.3% to 1.4%.  Do the math: if a mutual fund and an index fund both post a 10% return for the next year, once you deduct expenses (1.3% for the mutual fund and 0.15% for the index fund), you are left with an after-expense return of 8.7% for the mutual fund and 9.85% for the index fund.  Over a period of time (5 years, 10 years), that difference can translate into thousands of dollars in savings.   

3) Index funds have less turnover than mutual funds.  Turnover is a fund’s selling and buying of stocks.  Obviously, selling stocks may result in the application of the capital gains tax.  Do mutual funds write off this cost?  Certainly not.  They pass it off to investors.  Index funds, on the other hand, have lower turnover because, again, the stocks in a particular index are known and easy to identify, and the fund holds those stocks for a longer period of time.  According to an oft-cited study byJohn Bogle, over a 15-or 16-year period, investors get to keep only 47% of the cumulative return of the average actively-managed mutual fund, but they get to keep 87% of their returns in an index fund.  Again, let’s do the math: if you invest $10,000 in an index fund, that money would grow to $90,000.  In an average mutual fund, however, that figure would only be $49,000.  That is a 40% advantage or gain from investing in an index fund.  In cold, hard cash, that is $41,000.  Why would you want to pay Uncle Sam $41,000 in taxes when you don’t have to?

Let’s assume you don’t agree with this analysis because, say, index funds sound boring.  Yes, that’s true.  They ARE boring.  But they are more predictable than the average mutual fund.  And, as I illustrated above, they put more money in your pocket.  Consider this: if the reasons I listed above are true, they why don’t all these money and financial magazines tell you about index funds?  There is a simple reason why the covers of these magazines do not read “Index Funds The Most Rationale Choice!”  A magazine with that headline on its cover won’t sell as well as a magazine that boasts “Our 10 Best Mutual Funds For 2008!”  Ludicrous, you say?  Well, remember that a magazine company is in the business of selling….magazines.  Thus, to a certain extent, the information included within it must be attractive to buyers.          

If you still don’t agree with this analysis, keep in mind that the Greatest Investor of Our Time (Warren Buffett) echoes a similar philosophy: “The best way to own common stocks is through an index fund.”

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