Invest in Low Cost Index Funds

Posted on Posted in Finance

A few weeks back I received a letter in my mailbox from a unknown individual. I have reposted it below for you viewing pleasure. Enjoy!

Dear Sir or Madam:

I am from Bulgaria. Because of my being a foreigner, I have not been able to find a job as a financial advisor even though I have an MBA in finance and am more qualified for such a position. As a result, I came to the decision that if I’m not going to work as a financial advisor, nobody will.

Therefore, I would like to share with you my knowledge that the financial advising industry is a giant scam. If you do not believe me, read The Little Book of Common Sense Investing by John Bogle, the founder of the Vanguard Group, for the commentary on Chapter 9 of The Intelligent Investor by Benjamin Graham, the mentor of Warren Buffett. (The Intelligent Investor is available free online if you search Google for “The Intelligent Investor PDF”.) Those writings are straightforward and you do not need a degree in finance to understand them.
His writings teaches that you can perfectly manage your money yourself. All you have to do is invest in an index or unmanaged mutual fund, which owns all the stocks in the market or the stocks of the 500 largest US corporations, all the time, without any pretense of being able to select the best and avoid the worst. Your company surely offers a low-cost index find in your 401(k). The costs of index funds are between 0.1% and 0.5% versus the cost of 3% to 5% of managed funds.

Let me explain with those percentages mean. You have to subtract the percentage of the cost from the fund’s return to calculate the amount of the fund’s profit you will keep. For example, if a managed fund returns 6% annually and costs 3.5%, you will keep only 6% – 3 5% = 2.5% of the profit. Let us say, that you have invested $10,000 invested in the fund. Then, the fund’s annual return will be $10,000 * 0.06 = $600 of which you will keep $10,000 *(0.06 – 0.035) = $10,000 times 0.025 = $250 and give $10,000 * 0.035 = $350 to your financial advisor for fund management cost. If, on the other hand, you have invested in an index stock fund which returns 6% and costs 0.2%, the funds profit will be $10,000 * 0.06 = $600 of which you will keep $10,000 * (.06 – 0.002) = $10,000 * 0.058 = $580 and you pay $10,000 *0.002 equals $20 for the fund costs.

You may think that the profit of managed funds is higher and that compensates for the higher cost. However, nothing is further from the truth. If you do not believe me, refer to the writings indicated above. All financial data up to now shows that managed funds do not manage to do better than index or unmanaged funds over the long run. Secondly, all the returns of the fund may decline, the fees of owning the fund are permanent and never do. Therefore, the rock-bottom yearly operating expenses and trading costs between 0.1% and 0.5% give an index fund an insurmountable advantage. Late in his life Benjamin Graham praised index funds as the best choice for individual investors, as does Warren Buffett.1

Tell all your relatives, friends, everybody you know. Reallocate your money to a low-cost index or managed fund, fire your financial advisor who is robbing you, and watch your money grow.
Best wishes,

A friend

1 “There are a few investment managers, of course, who are very good- so in the short run it’s difficult to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listening to their siren songs, investors – large and small- Jack Bogle The Little Book of Common Sense Investing.” – Warren Buffett, Chairman of Berkshire Hathaway, 2014 Annual Shareholder Letter.