Wall Street is lined with brilliant people who get paid large sums of money to pick stocks and bonds. They are called active managers, and they’re the smartest guys around. And yet, you can usually get better investment returns simply by picking a few low-cost index funds. 

Really? How can that be? How can an individual investor outperform a Wall Street genius? Aren’t these guys really smart? Absolutely. Then how can I beat them? What’s their problem?

Ironically, the problem is that there are too many really smart people. Wall Street institutions largely dominate trading to such an extent that these smart investors effectively cancel each other out.

It’s All About Costs

That leaves one element as the deciding factor in investment performance: costs. And that’s a game you can win. Low-cost index funds tend to outperform the majority of active managers in one-year time frames, and the advantage becomes more and more pronounced over time.

Charles D. Ellis, the former Chair of the Yale Investment Committee and one of the titans of institutional investing, has called efforts to beat the market by choosing stocks and funds “a loser’s game.” He noted, “Over the very long term, 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” The performance of actively managed bond funds is usually even worse.

But what about using Morningstar to find winning managers? Can’t you just choose its 5-star funds? Won’t that enable you to beat the market? Morningstar is an excellent service, but every approach has its limitations. In August 2010, Morningstar released a study concluding, “Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

Warren Buffett’s Bet on Index Funds

Warren Buffett, one of our generation’s most successful investors, notes, “A very low-cost index fund is going to beat a majority of the amateur-managed money or professionally managed money.”

In fact, Mr. Buffett placed a well-publicized $1 million bet in 2008 with a hedge fund manager that a simple index fund can beat a portfolio of selected hedge funds. You can watch the bet in action at https://longbets.org. So far, Buffett is way ahead. Fortune reports that through seven years, the Vanguard 500 index fund selected by Buffett is up 63.5 percent vs. an estimated 19.6 percent by the hedge fund group.

Again, the indexing advantage comes down to costs. Index funds tend to cost about 0.20 percent, while actively managed funds often charge about 1.00 percent. There’s also a tax advantage: active funds tend to have capital gain distributions which can add to your taxable income, while index funds rarely have this tax impact. Over time, the high costs of active investing simply overwhelm performance.

A Three-Fund Index Portfolio is All You Need

So how can you get started? It’s easy. Index funds tend to be highly diversified, so you don’t need a lot of them. Many index funds contain hundreds of securities, some have thousands. These funds aren’t constructed to beat the market; their goal is to track a particular index.

There are thousands of index funds to choose from, but you can make it simple and effective by focusing on the major indexes. In fact, you can create a well-diversified portfolio with just three index funds that will largely track the performance of the overall stock and bond markets.

Here’s an example:

  • US stock market, such as the Russell 3000
  • World stock market excluding the US, such as the MSCI All-Country World Index ex-US
  • Barclays US Aggregate Bond Index, an index that tracks the overall US bond market

There are several funds that track each of these market indexes. Many of them cost less than 0.20 percent and some even cost less than 0.10 percent.

Index funds come in two varieties: as mutual funds and as exchange-traded funds (ETFs). Both have their advantages. Mutual funds can often be purchased at no charge, while ETF trades generally include commissions. ETFs can be traded during the day at a price you specify, while mutual funds can only be traded at the end-of-day closing price.

Whichever variety you choose – mutual fund or ETF – consider the index fund advantage. You may be surprised by how easy it can be to generate solid returns over the long term. You may even beat the big boys.

But more importantly, you will give yourself a better chance at reaching your long-term goals, and that’s what really counts. A CERTIFIED FINANCIAL PLANNER™ professional can help you choose what’s right for you.