I read a very interesting article in San Francisco Magazine recently, in which Mark Dowie discussed "the best investment advice you'll never get." Curious? So was I.
It turns out that the best investment advice you'll never get is advice that we at The Motley Fool have been offering (for free) for many years: Park lots of your money in index funds. I don't mean to be snide, though -- this advice can be hard to find, outside places like this. Most of the financial establishment makes big bucks by getting people to invest in pretty much anything else.
Dowie related a long story about how some bigwigs at Google, as the company's IPO approached in 2004, scrambled to offer soon-to-be-rich employees some critical lessons in how to best invest their new moolah. To do so, they invited some of the most respected financial minds. Here are some details on the company's series of "in-house investment teach-ins."
The illustrious invitees included none other than Nobel laureate William Sharpe, Princeton professor Burton Malkiel (author of the classic A Random Walk Down Wall Street), and John Bogle, founder of the Vanguard Group and a key index fund pioneer (read his Common Sense on Mutual Funds). Interestingly, they all pretty much offered the same advice: Stick with index funds, because they'll give you the market's performance at a fraction of the cost of other alternatives. Trying to beat the market is a losing game. Be wary of financial professionals who probably want to get rich off you via steep fees and transaction costs.
Another illustrious mind with the same advice is Warren Buffett. He's said more than a few times that the average investor would be best served by investing in a simple index fund.
A contrary view
So now that you've heard a number of financial heavyweights offer a powerful argument for just sticking with index funds, I'm going to suggest something that might sound crazy: Ignore that advice -- just a little. Don't get me wrong. I remain a big advocate of index funds, and I have a sizable chunk of my own nest egg in one.
I just also see some merit in complementing your core index fund holdings with some carefully selected mutual funds or individual stocks, in order to give you some chance of outperforming the market. After all, the stock market's historical average annual return is around 10%, while there are plenty of mutual funds out there with long-term records considerably better than that.
Some of the knocks against mutual funds today is that they're overdiversified, charge steep fees, sport high turnover, and in general don't serve their investors well. In all fairness, those knocks are based in truth. If one fund owns 100 different stocks, for example, and another owns 200, the latter is probably not gaining much from its extra 100 stocks. If anything, since any big winners will be spread over a much larger portfolio, it is probably less likely to outperform the market.
Steep fees are another performance killer. If a fund has an average return of 11.5%, it might look more attractive than the market's average 10%. But if its expense ratio is an annual cut of 1.8%, then you're actually going to lose to the market at the end of the day. (And then there are "load" funds, which can give your investment an immediate or eventual haircut of 5% or more.) Turnover is another demon, since the more that a fund manager buys and sells, the more shareholders pay in trading commissions, and the more gains end up taxed at higher short-term rates. Ick.
Overall, I agree with avoiding funds that feature those undesirable traits. But that doesn't mean you should avoid mutual funds altogether. By finding funds that have smart managers, low fees, low turnover, and often, rather concentrated portfolios, you can give yourself the opportunity to beat the market without the work of picking individual stocks.
If you'd like some help finding funds that fit this profile, try our Motley Fool Champion Funds newsletter. Consider, for example, the fund that was recommended in August 2004. It sports a 10-year average annual return of roughly 11.5%, no load, and an expense ratio of just 1.08%. Its top holdings include Microsoft
Impressed? Funds like this impress me, too. So that's my "best investment advice": Consider adding some actively managed mutual funds to your portfolio of index funds. And remember that if you want some candidates, a free trial to Champion Funds will let you read all of our research and past recommendations free for 30 days. Just click here for more information.
Longtime contributor Selena Maranjian owns shares of Microsoft and Time Warner. Microsoft and Pfizer are Inside Value recommendations. Time Warner is a Stock Advisor pick. The Motley Fool is Fools writing for Fools.