According to the folks at the Motley Fool, only ten of the ten thousand actively managed mutual funds available managed to beat the S&P 500 consistently over the course of the past ten years. History tells us that very few, if any, of these funds will manage the same feat in the decade to come. The lesson is simple; unless you are convinced you are capable of selecting the 0.001% of mutual funds that are going to beat the broad market, you would best be served by investing in the market itself. How? By beginning a dollar cost averaging plan into low-cost index funds, you can be absolutely certain you will out perform a majority of managed mutual funds on a long-term basis.
Indeed, the most successful investor in history, Warren Buffett, advocates that those unwilling or unable to intelligently evaluate individual stocks should invest in a low-cost index fund such as those offered by Vanguard. Why? Index funds boast three distinct advantages over their actively-managed counterparts:
They do not require corporate analysis or an understanding of accounting, financial theory, or portfolio policy.
They have almost non-existent expense ratios, providing a significant competitive edge over actively managed funds and almost completely ensuring superior long-term performance.
They are made up of dozens or hundreds of companies. This diversification reduces company-specific risk.
What is an index fund?
An index fund is a mutual fund designed to mirror the performance of one of the major indices (e.g., the Dow Jones Industrial Average, S&P 500, Wilshire 5000, Russell 2000, etc.) Unlike traditional, actively managed mutual funds where portfolio managers evaluate, analyze and acquire individual stocks, index funds are passively managed. Basically, this means they consists of a pre-selected group of stocks that rarely, if ever, changes. An investor that bought an index fund designed to mirror the Dow, for example, would experience price movements almost perfectly in sync with the quoted value of the Dow he hears on the nightly news. Likewise, an investor that built a position in an index fund designed to mimic the S&P 500 is, in essence, acquiring stock in all five hundred of the companies that make up that index.
