After a good year for the stock market, a lot
of investors are feeling it's safe to get back in the water.
And despite the recent scandals, a lot of money will be going
into mutual funds as the economy and market continue to recover.
But which funds should you consider?
after study finds that indexed funds are superior to managed
funds, particularly over a long period of time. In the face
of this evidence, why do so many investors still turn to managed
funds? Maybe it's because a lot of people still feel just
a little bit foolish buying an indexed fund. How smart can
it be to let a computer run your portfolio? How hard can it
be to find a manager smart enough to outperform a mindless
and intellectual appeal of managed funds comes from our daily
lives, where managing things usually trumps a strategy of
letting things take care of themselves. It's good to organize
your monthly bills rather than picking one up whenever you
think of it and paying it. It's good to keep your children
away from a hot stove rather than letting them discover the
dangers of life by trial and error.
Such real-life experiences can
mislead, though, when it comes to some financial decisions.
To understand the virtues of an unmanaged indexed fund, consider
the world of bagels. Did you ever stop to wonder how it is
that in Washington, D.C., where I live, and in every other
city of any size in America, bagel shortages never happen?
not impressed. What's the big deal? But think of the army
that has to work together to have that fresh bagel waiting
for your random appearance at the local bagel shop. Who coordinates
that team? Who told the farmer to grow enough wheat? Who made
sure there were enough mills to grind the flour, enough trucks
and truck drivers to move it around the country? Bagels have
no czar. No one is managing the process. How can bagels be
plentiful without someone being in charge?
Super Bowl rolls around each January, no one sends out a directive
to the flour mill to tell them to grind extra flour for hot
dog buns and sub rolls. The Super Bowl comes and goes without
a shortage of hot dog buns, and still, there are plenty of
MUCH KNOWLEDGE. The bagel market doesn't work
perfectly. Sometimes a baker will have an oversupply of one
flavor or another. Sometimes I might have to make two stops
to pick up enough bagels if I decide to throw a brunch for
50 friends on the spur of the moment. Would the system work
more smoothly if someone were managing it?
enough, the imperfect, unmanaged marketplace outperforms the
conscious planning of experts. The Soviet Union was famous
for managing its economy into failure. Go to Cuba where everything
is managed, and you'll find everything but despair in short
supply. The only times America has sustained shortages is
when the government controls prices. In the 1970s, we had
gasoline shortages with price controls and an energy czar.
a conscious planner do a better job than the unconscious marketplace?
The simple answer is that planning for things of that magnitude
requires too much knowledge dispersed in too many different
brains spread across too much space and time.
STRATEGY. Coordinating that knowledge requires
more than an expert with a supercomputer because the nature
of that knowledge is often intangible and can't be reduced
to digital information. In the marketplace, prices encourage
people to do on their own what a coordinator or planner would
have to figure out and command. When demand goes up, prices
rise and tell suppliers to produce more. Shortages and surpluses
are self-correcting when prices are allowed to adjust freely.
understand how the bagel market, while imperfect, functions
smoothly without a manager, you can begin to appreciate the
wisdom of buying an indexed fund. Prices, after all, capture
information. The best stocks end up being more expensive than
those with worse prospects. The expected return is that of
the market as a whole. Bargains can't be identified in advance.
Turns out the best strategy is to avoid the fees and tax consequences
of managed funds and take the return of the market as a whole.
who are skeptical of indexed funds (and their skepticism is
often self-interested) like to point out that one fund, Legg
Mason Value Trust, has outperformed the S&P 500-stock
index every year for the last 13 years. The indexers respond
that with over 6,000 actively managed funds, surely some will
outperform their benchmarks purely by chance. But because
you can't know in advance which funds will be the lucky ones,
you're still better off investing in indexed funds.
Thirteen years in a row—could it be pure luck? How can
it be anything else? Right now, Amazon ( AMZN ) is Value Trust's
single largest holding, almost 10%. Do you think fund manager
Bill Miller knows something about Amazon that no one else
knows? I doubt it. He's simply following a hunch the same
way some bettors choose black in roulette or use their birth
date for picking lottery numbers.
next time you're tempted to identify the hot manager in the
hot sector, remember the humble but plentiful bagel. Rely
on the wonders of the marketplace. You're likely to make more
money, and you'll free the time you would spend picking the
right fund for more rewarding pursuits that don't involve