Farrell: Investment fears prompt question on index funds

Q: Since I am so fearful of investments of any kind, I thought I would ask you a question about them. I have an IRA that I have been wondering if I should roll over into an index fund. I’m almost 64. Is that a wise or unwise thing to do?

Deborah

 

A: I’m skeptical that it would be a wise move to embrace an index fund. There are risks associated with putting your money to work in volatile equities. James Montier, the savvy investment maven at the Boston-based money management firm GMO, wisely counsels individuals to “never invest in something you don’t understand.” It’s one of his seven immutable laws of investing.

As you know from reading this column, I’m a fan of investing in broad-based, low-cost index funds for the equity portion of a long-term portfolio, such as retirement savings. Investing in index funds is called passive investing since the goal is to match the performance of the underlying market index. Actively managed mutual funds strive to consistently beat the market.

The scholarly evidence is overwhelming that index funds consistently outperform actively managed mutual funds. Passive investments in broad-based market index funds have outperformed the average active manager since 1980, according to Burton ­Malkiel, emeritus professor at Princeton University and author of the personal finance book “A Random Walk Down Wall Street.’’

A major reason for the performance gap is fees. Fees on index funds are extremely low compared to actively managed funds. You aren’t paying high-priced money managers and researchers to come up with market-beating trades. For example, in 2012 the average expense ratio of actively managed equity mutual funds was 92 basis points. (A basis point is one one-hundreth of a percent.) The comparable number for equity index funds was 13 basis points, according to the Investment Company Institute.

One of my favorite investing stories involves Robert Wilson, the late, legendary hedge fund investor and philanthropist. Wilson started investing in 1949 and parlayed a small stake into a fortune. He retired in 1986 to focus on giving his money away. He told Brett Fromson of thestreet.com in a 2000 interview that when he retired he divided his money among roughly 20 aggressive top-flight money managers. He ended up firing 14 over the years, but kept roughly the same number of managers overall.

“I would say that if I’d put half of my money … in an index fund — the S&P, the Vanguard fund — and half of my money in two-year Treasury bills, I would have done almost as well as these managers did,” Wilson said.

That said, owning an equity index fund simply means you will do as well as the underlying market index (minus fees) and as poorly as the index (minus fees).

The stock market is volatile. You should only invest in the stock market if you’re ­comfortable psychologically and emotionally with the manic moods of investors and if your finances are deep enough to ride out the inevitable downturns. So if you aren’t in stocks, I wouldn’t embrace the investment at this point.

Of course, if you already own stocks in your IRA as part of a well-diversified portfolio, then I would consider putting that portion of your portfolio into an index fund.

 

Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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