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The Experts' Secrets

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The following, although Hitchcockian in the terror that it will cause some, nevertheless has to be faced.

A typical 401(k) plan might offer five or more different stock mutual funds. The chances that you, dear reader, will pick one or, even less likely, a combination of more than one, that will outpace the performance of a broad-market index fund can perhaps be measured by referring to a June 30, 1998, Wall Street Journal article. That article reports the results of a 1992 challenge that the Journal gave to five very experienced mutual fund "experts." These experts were asked, "Out of all the mutual funds in the whole great big wide world, if you had to pick one to get the highest rate of return over the next 10 years, which would it be?

These were the "experts" mind you. These were individuals who make very highly paid careers out of sounding pretty good when they answer this kind of question. These were the Wisest of the Wise. Now, as the Journal noted, the 10 years isn't up yet, but six years ought to tell us a little bit.

As it turns out -- it tells us a lot. Tells us everything, some might argue.

Out of the five, none picked a fund that outperformed the S&P 500 Index, and two picked funds that were, basically, total disasters. While the S&P 500 returned 196% over the time that was measured, the five experts picked funds that returned between 27% and 192%. The average return of the five was 133%.

Of course they never learn either. When asked to pick new funds for the next 10 years, each of the "experts" who hadn't picked an index fund went out and picked a new actively managed fund. We'll come back and check how they're doing, from time to time.

To be fair, a few things need to be pointed out. One of the experts did pick an index fund, although he picked a fund which indexed the total stock market of about 6000 stocks, and that fund came very close to matching the S&P 500 return. That index fund was not the very best performing of the experts' picks, either, because one of the funds did outperform it. So it certainly is the case that some (a very, very few) actively managed funds do outperform some index funds over extended periods of time. But even when they do so, it's by very little. It's really just not worth the risk of severe underperformance.

The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors. In fact, one of the reasons that actively managed equity funds underperform stock index funds is because they are spending so much money to advertise -- money that otherwise would be invested on behalf of the mutual fund shareholders.

Of course, the average domestic managed fund doesn't actually perform nearly as poorly as the ones picked by these experts. The average actively managed domestic equities fund trails the average passive equity index fund by about two percentage points per year, so just picking funds by throwing darts would almost certainly have served you much better than listening to these experts.

Even if you're convinced that an S&P 500 index fund is the right one for you, there may still be a problem. What if your 401(k) doesn't offer an index fund? Remarkably enough, according to a 1996 study reported by the Department of Labor, most 401(k) plans don't include an equity index option. If that's true of your plan, then start lobbying your employer to get one, Fool. Rally your fellow employees to the cause by sharing these statistics with them. When a group of you persistently asks for this option, few employers will continue to deny it. It's your money and it's your retirement, so don't be afraid to ask for what you need to build that stash. The old adage about the squeaky wheel is true, so just hang tough and sooner or later your employer will see the light of day. To assist you, we've drafted a letter to your plan administrator that clearly spells out the arguments in favor of indexing. Customize it, print it out, hand it to your employer and keep squawking until there's an index fund made available to you in your 401(k).

If your plan does offer an index fund, woo-hoo! You may just decide you don't need to read any further. If you currently have money in actively managed mutual funds while there is an index fund available, consider saying to yourself, as so many movie characters do, "Let's get out of here," and transfer that money to an index fund.

If your plan, however, is one of the approximately 58% that doesn't offer an index fund (or if you think that you're really smarter about picking funds than the self-anointed experts) read on. We'll show you how to pick the funds that are closest to an index fund.

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