Would you say you’re comfortable with the world of finance? Do you know the ins and outs of a mortgage? Can you competently do your own taxes every year? Does the legalese of a loan make sense to you? If you’re like most people, you’ll probably answer those questions with a resounding, “No!” In fact, most of us feel lucky if we’re able to successfully write checks and pay our bills. Many people struggled through high school or college economics and now we’re only too happy to put our bills on AutoPay or trust our banking apps to keep track of our purchases for us. Similarly, we’re very glad to hand our taxes over to an account or a software program like TurboTax every year. But have you ever wondered why that is?
It’s not because most people are stupid; rather, it’s because we lack adequate education about managing finances and making investments. And although it’s easy to ignore this lack of knowledge by relying on TurboTax every year, the reality is that we’re missing out! That’s because we could make a lot more money if we had the financial knowledge necessary for making smart investments. So, over the course of this summary, we’ll follow along as the author explains everything you need to know about making smart investments. And we’ll start with his cardinal principle: why index funds are the best type of investments.
Chapter 1: Understanding Investment Funds and The Stock Market
How much do you know about the stock market? We see it on the news all the time, with headlines announcing that the stock market has “closed for the day,” or that a certain type of stock has decreased in value or suddenly gone up in value. But what does any of that mean? Most of us don’t know much about how it works. This is especially true for members of our younger generations, as our education system often neglects to teach them practical financial tips for life. So, before we dive in to the stock market’s actionable tips for our daily lives, let’s take a minute to learn a bit about how the stock market works.
We can think of the stock market as being like the grocery store. If you want to buy groceries, you go to the supermarket, right? Similarly, if you want to buy stocks, you go to the stock market. Just like a grocery store, the stock market offers stocks or “mutual funds” in pretty much every flavor you could imagine. Unlike the supermarket, however, the stock market isn’t in a single, physical location and it doesn’t have fixed business hours in the same way that your local grocery store might close at 10:00 pm. Instead, you can purchase stocks online. (Yes, it’s really that easy!) It might surprise you to know that you don’t have to be a professional investor or even someone with a great deal of financial acumen; anybody can buy stocks! In fact, with just a little friendly financial advice, you can invest in stocks through your employee retirement plan (often called an IRA) or something called a brokerage account.
But even though the stock market can be simple and accessible to the average person, the author observes that it’s also very unstable. And it is this very instability that makes it an unattractive option for many smart investors. That’s why, instead of putting their money in stocks, many investors believe that it’s wiser to put their money in something called an “actively managed fund.” An actively managed fund is sort of like a community bank; multiple investors put their money into this fund and their money is then invested in stocks by an active fund manager. The active fund manager’s job is to keep an eye on everyone’s money and on the stock market to ensure that your money is being invested in the best stocks. The theory behind this strategy is that the presence of an active fund manager mitigates some of the risk. Instead of incurring the risk of managing your stocks on your own and watching the stock market all the time, you can hire someone to do that for you. Theoretically, your active fund manager should also be able to move your stocks accordingly so that you don’t lose all your money if the value of a stock plummets.
At the heart of this system is the belief that you can beat the unstable stock market through a series of carefully calculated moves and smart investments. However, the author observes that this theory is even more risky and unwise than investing directly in the stock market! Here’s why: forstarters, an actively managed fund is incredibly expensive. You might think that isn’t a deal breaker; after all, if you’re paying an active fund manager to manage your stocks and deliver a huge return on your investments, maybe the expense is worth it! But the author asserts that that isn’t necessarily true. That’s because you’re actually more likely to lose money in the long run! Why? Well, for starters, the financial experts who manage your fund don’t come cheap. And, to make matters worse, they rarely disclose the realities of their fees upfront. Instead, they woo you by touting their history of success and their success rates convince you that their expertise is worth whatever you might pay them. Unfortunately, however, many people fall for this before considering the true cost of their fund manager and they quickly come to regret their decision. That’s not always because the fund managers do a poor job, however; it’s usually because they’re so expensive that their services just aren’t worth the massive amount of cash you have to cough up! In fact, the author observes that, even if the stock market was perfect, it’s totally possible that you could lose a lot of money on fees for your fund manager alone! But although fund managers are incredibly expensive, they aren’t your biggest liability when it comes to loss of profit. Instead, the author explains that your biggest certain loss is due to the instability of the stock market. It’s not feasible to assume that you can beat it or rely on it. And no matter how carefully managed your active fund is, it will never be capable of delivering profits greater than what the companies who produce the stocks are earning.
If it could provide you with that amount of profit, then it would probably be worth the high cost of running an actively managed fund! But because this isn’t possible, your fund is guaranteed to hemorrhage money you can’t afford to lose. You can also guarantee that your actively managed fund will never give you the return you hoped to see on your investments. This means that, ultimately, an actively managed fund is not the savvy, system-beating idea many people think it is. Sadly, however, the author notes that many people neglect to do their research and consider these facts ahead of time. Actively managed funds are popular because so many people believe they can beat the stock market using strategy. And even if those people are wrong in their beliefs, their friends don’t know that! So, many people blindlyfollow the choices of their friends, assuming that a certain type of investment must be a good idea if so many of their friends are doing it.
So, don’t make the same mistake! And now that we know to avoid this type of investment, it’s time to take a look at the investments that are a good decision!
Chapter 2: Index Funds
The author believes that index funds are the way to go, and in this chapter, we’ll learn why they’re a better investment than actively managed funds. We’ll start by unpacking the difference between an index fund and an actively managed fund. Professional investor and financial analyst Jason Fernando has written a great deal about the value of index funds and he’s passionate about making investment information accessible. In the spirit of this passion, he has crafted a simple guide to index funds which explains that:
“An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index. Index funds have lower expenses and fees than actively managed funds. Index funds follow a passive investment strategy.Index funds seek to match the risk and return of the market, on the theory that in the long-term, the market will outperform any single investment. "Indexing" is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio whose holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well. There is an index, and an index fund, for nearly every financial market in existence. In the U.S, the most popular index funds track the S&P 500.
Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities- picking, market-timing portfolio manager described above. One primary advantage that index funds have over their actively managed counterparts is the lower management expense ratio. A fund's expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees. Since the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock-selection process. Managers of index funds trade holdings less often, incurring fewer transaction fees and commissions. In contrast, actively managed funds have larger staffs and conduct more transactions, driving up the cost of doing business.
The extra costs of fund management are reflected in the fund's expense ratio and get passed on to investors. As a result, cheap index funds often cost less than a percent —0.2%-0.5% is typical, with some firms offering even lower expense ratios of 0.05% or less—compared to the much higher fees actively managed funds command, typically 1% to 2.5%. Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds, and struggle to keep up with their benchmarks in terms of overall return. If you have an online brokerage account, check its mutual fund or ETF screener to see which index funds are available to you.
Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2018, according to Morningstar Research, investors poured more than US$458 billion into index funds across all asset classes. For the same period, actively managed funds experienced $301 billion in outflows. The one fund that started it all, founded by Vanguard chairman John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. It posts a one-year return of 7.37%, vs. the index's 7.51%, as of July 2020, forexample. For its Admiral Shares, the expense ratio is 0.04%, and its minimum investment is $3,000.”
As you can see from Fernando’s explanations, index funds are much more stable and cost effective than their actively managed counterparts. That’s why the author believes that choosing the cheapest index fund is the smartest way to invest your money. He also believes that you should be cautious when approached with new investing trends. Investing fads come and go, but only the truly stable and profitable methods will stand the test of time. And as you can see from the previously mentioned data, index funds have been around since the 1970s. This means that they’ve been around long enough to grow, mature, and stand the test of time. And as a result of their long and stable history, investment experts like the author have had the opportunity to study and evaluate them. This study has ultimately led investment experts to conclude that index funds are the best option.
Chapter 3: Final Summary
Many people are handicapped by their lack of financial knowledge. This means that they often avoid pursuing investments that could bring them a lot of money. But if this describes you, the good news is that you don’t have to work on Wall Street or have a degree in Economics to make smart investments! The author uses his years of experience as a CEO and investor to make complicated financial concepts simple and provide you with all the information you need to invest your money wisely.
By comparing actively managed funds and index funds, the author demonstrates that index funds are a better investment. This is because they are more stable, less expensive, and more likely to reward you with a profitable return on your investment. So, if you’re interested in investing, don’t waste time trying to learn everything there is to know about investments. And don’t waste your money on the wrong type of investments! Instead, start smart by investing your money in an index fund.