Many investors don’t realize that stock market indices, throughout the history of the stock market, have outperformed the average mutual fund. Very few mutual funds are able to consistently outperform indices throughout the course of time because:
- They charge high management fees which erode any profit potential, and
- What works in one decade doesn’t work in another decade.
“The best proof of the market’s intelligence is that even the professionals can’t keep pace with it. Over any period of a few years or more, about 80% of actively managed mutual funds lag behind the market. They\’re weighed down by the salaries of their managers, by research costs, by marketing expenses, by fees paid to financial planners, by trading expenses.” Canadian Business Online
Furthermore, mutual fund histories can be deceiving, due to survivor-ship. Losing mutual funds tend not to survive. They either disappear, or they are incorporated into larger, more successful mutual funds. Therefore, when you look at the prior performance of existing mutual funds, you are automatically discounting all the mutual funds that have failed or that have ceased to exist!
How can you combat this? One way is to gamble on your luck. If you can always pick the “hot” mutual fund at the right time, you will outperform the index. But how lucky can you be?
Another way is to buy stock yourself. TD Waterhouse is a great discount broker which charges minimal transaction fees. However, buying individual stocks takes significant capital (i.e. to buy enough to fully diversify your portfolio), and time (i.e. to research company fundamentals).
A third way to ensure that you outperform the average mutual fund is to buy index funds. Recall that a stock index will outperform the average mutual fund. Dubbed the “Couch Potato Portfolio,” this strategy entails diversifying across several index mutual funds. To invest in the Couch Potato Strategy, buy the market by investing in a small collection of low-cost index funds. These funds passively follow the ups and downs of market indexes, such as the S&P/TSX Composite index of Canadian stocks or the Standard & Poor’s 500 index of U.S. stocks. The key advantage of the Couch Potato strategy is that it gives you wide diversification among hundreds of stocks and bonds at rock-bottom cost.