Download Mini Lecture 8

Mini Lecture 8
Question 11: Why is paying someone to manage your mutual fund a bad idea?
A prominent business periodical used to conduct an annual experiment. A monkey would throw darts at
a board that was covered with a listing of stocks. They constructed a portfolio or mutual fund consisting
of all the individual stocks that the monkey hit with a dart. Every year the fund based on the dartthrowing monkey earned a higher return than most professionally managed mutual funds. Why do
these professionally managed funds perform so poorly?
In general, there are two types of mutual funds: index funds and managed funds. Index funds are based
on a broad-based stock index like the S&P 500 or the Russell 2000. These funds are lightly managed,
and they are good examples of the passive approach to saving for retirement. This approach can be
described as “buy and hold.” Conversely, managed funds are heavily managed by someone who gets
paid a fee to continually analyze individual assets and adjust the composition of the fund with lots of
buying and selling of individual assets. These management fees can be quite high and are paid out of
the fund itself. Managed funds are an example of the active approach to saving for retirement. The
active approach involves a lot of trading and trying to time the market to “buy low and sell high.” Active
trading also involves a lot of research. You can do this on your own or you can pay someone to do it for
you, which is the case with a managed fund.
What many people may not realize is that each year index funds outperform most managed funds. That
is, many people are paying management fees to someone who is getting a lower return than the
comparable index fund. This is consistent with the general principle that passive saving is superior to
active saving. This is why listening to someone who has advice about specific assets is a bad idea. (The
exception is when someone has inside or private information.)
Why is it so difficult for so-called experts to “beat the market,” or even beat a dart-throwing monkey?
The answer lies in two related concepts: the efficient market hypothesis and the random walk of asset
prices. I will refer you to the readings, especially Landsburg Chapter 19 (Random Walks and Stock
Market Prices), to learn more about these two concepts.
Does this mean that all financial advice is worthless? Not at all. Advice that consists of general
principles is useful. Here are a few general principles that you should follow in saving for retirement.
(See the Cowan and Tabarrok, chapter 10 for details.)
General Advice
1. Diversify
Buy a wide variety of assets in order to minimize risk.
2. Use compound interest
Start saving early and save consistently. Because of compounding, saving five years earlier in life
can make a big difference in the value of your savings at the beginning of retirement.
3. Avoid high fees
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A good rule of thumb is to avoid funds with a management fee greater than 1%.
4. Beware of stock price bubbles
In the long term, stocks outperform bonds by a significant amount, but in the short term, stock
prices are much more volatile than bond prices. This is why one should start to shift out of
stocks and into bonds as one approaches retirement.
5. Be aware of inflation and tax risk
Do not forget the possibility that inflation or tax rates may increase significantly over the course
of your life. Both of these will lower your after-tax real return. Roth IRAs are one way to hedge
against tax rate risk, and inflation-indexed bonds are one way to hedge against inflation risk.
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