Why We Always Recommend Buying Low Cost Index Funds

by David Ning · 18 comments

Many of us recommend low cost index funds for the individual investor. Some of the articles provide a good argument, while some don’t even give a reason at all. This article illustrates what happened with one of my reader’s investment portfolio so we can judge for ourselves whether low cost index funds are for us.

MoneyNing,

Like you, I am in the west coast and when I get to the office, the US stock market already opened. Sometimes I check the performance of my stocks, and other times I do not (actually, I check it all the time). When I did check it this morning, I noticed that the money in my taxable account went down by 12%. I looked into the details and realized what happened. One of my stocks Wavecom (WVCM) just reported earnings and the stock went down 20%. Since I had a ton of money in this stock, I was hurt bad. Really bad. Panicking, I sold WVCM along with Apple (AAPL) because I was afraid Apple was going to report bad earnings too. I’m really pissed off right now because I checked after hours and Apple is up more than 10% since I sold it. I realized I was being dumb and really want to see if you can recommend some low cost index funds for me to own since I am clearly not cut out for stock picking.

Regards,
MoneyNing Reader


His story is all too familiar. I remember making similar mistakes in the stock market when I first started investing because I too panicked when a stock didn’t go the way I thought it would. The beginning of my investment career were filled with moments of me selling low and buying high because when stocks go down, I will sell and then when they go up, I will buy them again think I will miss the boat. Over time, I managed to learn from my mistakes but the lessons were very costly.

When stocks go down significantly, some of us almost get this sickening feeling in our stomach. Sure, any individual stock could go up significantly and boost our portfolio’s performance, but the risk is also very high.

Some people who pick individual stocks don’t even know much about the company. In essence, many of these people are treating the stock market like a casino. Furthermore, many of us don’t have the tolerance to properly manage the emotional roller coaster of individual stock prices going up and down. We end up buying high, and selling low because of our greed and fear.

Everyone who have individual stocks in their portfolio should examine their risk tolerance not when times are good (when stock prices are soaring) but when times are bad (the day the price drop significantly). Only in adversity can we truly determine our risk tolerance.

Low cost index funds on the other hand are much less volatile. No one will become rich overnight, but it is a much more dependable way to investing in equities. It gives us comfort that our portfolio would not get crushed if something horrible happens to any particular company (e.g. Enron), and will help us better see the long term benefits of investing in the stock market.

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{ 18 comments… read them below or add one }

Calvin July 26, 2007 at 9:45 am

I agree completely. Look at the market again today. If you are in it for the long term, there’s no reason to pick stocks since you never know how badly you will be hit.

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Pinyo July 26, 2007 at 9:54 am

This is a good story and low cost index fund is definitely a good way for beginners to get into the market.

However, I would encourage everyone to at least use a small portion of their porfolio to learn more investing. If you are not up for it, create fake portfolios, track them, and see how they would perform.

I recently did an analysis on how anything other than low fee funds can really destroy your wealth. For example, a fund with 2% expense ratio can take away almost half of your investment in 30 years. Personally, I am starting to transition from mutual funds to ETFs. This should save me a lot of expense fees in the long term.

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Calvin July 26, 2007 at 10:04 am

Pinyo – Yeah seems like those management fees really eat up your portfolio. Imagine when your mutual fund goes down 5% that year and the management fee adds another 2%.

I also heard that mutual funds can have captial gains even if they have a down year. I’m not sure how that happens but I just remember something like this. Maybe someone who knows more can share their take on this.

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MoneyNing July 26, 2007 at 12:27 pm

Calvin: I believe whether someone should pick individual stocks or not will depend on how emotionally detached he can be with the market plus his knowledge of the stock and market (which can be learned).

Mutual funds are required to pay out distributions if they sell a security at a profit no matter what happens to the overall fund performance. That’s why you are getting this. I probably should do a full write up on this just so everyone is clear. Stay tuned.

Pinyo: Expense ratios are another one of those things that kill portfolio performances. Thanks for bringing that up.

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Pinyo July 27, 2007 at 5:45 am

Calvin – yeah, it hurts when the fund goes down and give you a distribution. It hurts to buy a fund late in the year, get the distribution, and essentially pay other people’s capital gain taxes. A fund can distribute even when it looses money because by law, funds have to distribute any taxable gains from investing to shareholders each year. So if the fund sell some of its winning stocks, you get stuck with the distribution. For example, my $4,000 holding in HFCGX distributed $600 last year. Luckily, it was in my IRA so I didn’t have to pay tax.

MN – no problem. thank you.

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Carl July 27, 2007 at 7:09 am

I think one problem with mutual funds is that they distribute capital gains, but they do not distribute investment losses. That means if they sell a position at a loss, the fund takes the income offset for itself, they do not distribute it to the fund holders to lower their taxes. When they sell a position at a gain, they distribute this gain so the fund holders must pay the usually short-term capital gains. It does not seem fair, and it is why I do not hold mutual funds outside my 401k.

Even in a 401k index funds are a good idea. Seems many mutual fund managers are too smart for their own good, and waste a lot of money in transactions when buy-and-hold is usually the most effective equity strategy over the long term.

There is an excellent book about this called by David Swenson. Does anyone remember the name?

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MoneyNing July 27, 2007 at 8:41 am

Carl: I think the book is called Unconventional Success: A Fundamental Approach to Personal Investment (I just did a search on Google).

Actually I’m starting to think more and more that low cost index funds are the way to go even if I can pick individual stocks. Yes they are quite boring, but it is what I need since I don’t want to manage so much money since
1) I’m not extremely good at it.
2) I don’t have time to handle the research needed along with the blog, my job and my family
3) read 1 and 2 a few more times…

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Calvin July 27, 2007 at 9:52 am

Pinyo: Geez $600 dollars distribution for $4000?.? That’s a pretty big percentage. I guess you are buying those actively managed mutual funds huh?

Carl: Umm. I wonder what’s the logic behind this since I assumed someone has thought about this scenario and deemed that it is fair to only tax gain distributions.

All: Thanks guys for the explanations.

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Pinyo July 27, 2007 at 11:45 am

Calvin: I was surprised too since it was a low turnover fund. I have since switched to ETFs.

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MoneyNing July 27, 2007 at 2:47 pm

Pinyo: I think ETFs are much better than mutual funds in general because they trade like a stock which means they are much more flexible (cheaper, can be sold immediately if need be etc etc).

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Pinyo July 27, 2007 at 4:06 pm

I agree. There is one situation where mutual fund is better, that is if you have small amount of money to add regularly. With no load fund, you incur no trading expense. However, you will get to the point where you have enough money in the fund to make an equivalent ETF more attractive.

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MoneyNing July 27, 2007 at 4:24 pm

Pinyo: That’s true but you can always use something like Zecco if you are worried about fees.

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MoneyPerk August 15, 2011 at 10:14 pm

I agree that index funds are very safe, and almost crash proof. But, it’s hard to find good funds that will give you the return on investment that you want. I like stocks because there are ways around to decreasing your risk involved. For instance, information you get about a particular company can significantly decrease your risk. Another way is to analyze stocks carefully. If done correctly, you can see how much the company has in debt, how much they continue to spend, or if they have enough invested in assets and have a promising cash flow statement.

I don’t want to give the wrong impression and lead people to think that index funds are not a good investment. They are good investments and should be components within the portfolio for sure.

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Charles November 18, 2011 at 9:40 am

I too sympathize with your reader. Been there many times over and over again. I’m contemplating just quitting the market because it’s been such a frustrating year. But it’s almost like an addiction too. Every time I think about quitting, I end up depositing more money.

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Mark Hersey June 18, 2013 at 12:53 pm

FYI: NO, it’s not as unfair as you folks might assume. Mutual funds use realized capital losses to offset the realized capital gains BEFORE paying the net positive capital gains out as distributions. And they carry the net realized capital losses from year to year, in order to offset subsequent years’s realized capital gains.

Obviously, they cannot make you pay IN the net realized capital loss come distribution time! Unless they made you “cash in” some shares to do it. This is what the inverse transaction would look like. But the government has never been as much interested in paying you for your net realized capital losses (thus the $3K limit per year), as in making you pay for net realized capital gains (no yearly limit).

Which all becomes one big reason why investing in mutual funds near before, at, and near after, the bottom of the market is fabulous. You can go for years before paying any taxes on net realized capital gains on the mutual funds sales due to the net realized capital loss carry forward generated by panic and other selling while going downhill from the top to the bottom of the market. And you can read the various fund annual reports to find out who has large net capital losses being carried forward. Unfortunately, large net realized capital loss carryover usually means large turnover rate, and thus potentially won’t last as long as their size might otherwise suggest.

While index funds will, due to low turnover rate, have little of such net realized capital loss carryovers compared to other types of funds, such losses still exist and, due to the same low turnover rate, will still take a similarly long time to consume the net realized capital loss carryovers as the average fund. Though maybe less so if the average index fund shareholder is less prone to panic selling than the average actively managed fund shareholder.

One benefit of net realized capital gain distributions (or similar small yearly managed exchanges) is that it allows you to pay a zero (or nearly so) tax rate on smaller (especially index fund) gains made in children’s UGTM accounts as they grow (because of the children’s standard deduction), instead of paying for a huge gain (not fully offset by standard deduction) while selling just before paying for college or other “later grown up” expense. This can be used instead of a college savings fund, especially if you are not sure your children will be going to college.

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Mark Hersey June 18, 2013 at 1:09 pm

Because index funds have comparatively little realized capital gains (due to not having turnover except for net shareholder sales days), they accumulate unrealized capital gains much more so than actively managed funds. Thus the distributions are generally smaller than for actively managed funds, and you generally pay taxes for more of your gains at the time you yourself cash out by selling some of your shares. This is another seldom described reason why indexing is superior to most actively managed funds, at least the ones without a tax management sales strategy and similar low turnover. Such funds do exist and are usually found by having the words “Tax Managed” or similar wording in their names.

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Leo McHale December 28, 2013 at 9:19 am

Vanguard Total Stock Market Index Admiral Fund, .05% expense ratio. Remember, markets are unpredictable, costs are forever

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Jeff March 27, 2014 at 8:11 pm

Unless you are a stock market Guru or know more than anyone about an individual stock (at which point you may legally have insider knowledge and cannot trade it), if you want to invest in the stock market then there are only two symbols you should consider: SPY and VTI.

The S&P 500 and the Wilshire 5000. Total diversification and as the master Bogle long ago proved, you will beat the majority of ‘professional fund managers’ year in and year out, again and again.

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