Why does everyone recommend Passive Index Funds and to avoid Timing the Market?

So far I've written two articles that have mentioned the benefits and advantages of investing your money in order to help you achieve your big financial goals, such as having enough money for your lifetime or making yourself into a millionaire with much less effort than you might assume.


But for many people, investing might be an unfamiliar thing and there are a lot of questions or concerns right at the start such as:


  1. How do I know I'm investing into the right things?

  2. I don't understand the markets, should I just trust my money to a professional?

  3. What if the value of my investments drop right after I put my money in?

  4. Should I wait for the price to be a bit lower before getting in?


... and many more.

An example of the thought process of a new investor who is hesitating to put their money into the financial market

These are pretty much the same questions that I was asking before I ever made my first investment, and even for a while after that. It's hard not to wonder if "now is the right time" or "where will I get the most for my money" whenever you have a chunk of money that can be put away for the future.


It has taken a lot of reading, research, analysis, experimentation and simply learning from my own mistakes but over a number of years I've managed to come to my own understanding and interpretation of the "buy and hold, be diversified and invest for the long run" strategy that is broadly recommended by the financial independence community.


Note I didn't say "come up with my own strategy"; the strategy I follow isn't anything revolutionary when it comes to long term investing but as a curious person with a passion for personal finance I was always trying to find the cracks or the edge to give me an advantage. Instead what I kept finding was evidence that the simple approach is the right way to go, and hence I describe this as coming "to my own understanding".


Admittedly I do feel like there is still much more to learn as the learning never stops, but I figured that I am a ways further down the path than some others and perhaps in their own search for clarification they might come across this article. If that's the case then the best thing I can do is impart some of my own knowledge to them so they feel as though they've made a little progress as they move onto the next thing for their financial independence journey (maybe onto another article of mine?).


Passive Funds vs. Actively Managed Funds


I think an interesting place to start is by addressing the comparison between passive funds that track an index and actively managed funds where the fund manager attempts to beat the market. As someone on the journey towards financial independence you will find a lot of recommendations to invest your money into a passive index fund; I'd like to go one step further and show you why an active fund with "better performance" can still be worse than a passive fund, and this applies to both long term and short term time frames.


The realm of investing into the financial markets is one that could feel quite alien, complex and very confusing for those of us not working in investment banking or on Wall Street. Traders, fund managers and bankers in general will throw around terms such as stocks and shares, bonds, options, puts, swaps, futures, commodities, leverage, derivatives, bids, asks and many more in order to explain what they do, or not. More likely is that they’re just using these terms to confuse you while trying to make themselves sound really smart.


Most of us won’t ever know what they are talking about, especially when you see the complex equations, algorithms and numbers behind "figuring out the value" of a financial product. These people are indeed smart, there’s no doubt about it despite my earlier comments on them just trying to make it seem that way. They went through all the schooling and training to land their prestigious jobs, and they have to work really long hours to keep up with the financial markets. For that effort alone they are worth the big salaries that they earn, right?


Since they are the ones who understand and work on all of this it means us mere mortals have it easy. We can just entrust them or their institutions with our money and they will do all the hard work, all the calculations and put in all the long hours to earn us a profit. For their troubles they get to take a nice fee and from our perspective it’ll be fair and it’ll be worth it, right?


Here’s something I want you to look up:


“Monkey versus stock picker”


Take a look through the results and material and what you will find is that there has been an experiment where researchers decided to see how things would turn out if a monkey used some darts to pick out a portfolio of stocks. The result is that the average monkey (as they didn’t do this experiment with just one monkey) outperformed the stock market index over a period of time.


The index is typically the benchmark of investment performance as it represents a set of companies in a market that can be used to represent the performance of that overall market itself. If your portfolio performs better than the index then you are outperforming the market, and if your portfolio performs worse then you are under performing.


A chart representing the S&P 500 index and what is over performance vs. under performance

To make sure this wasn’t a lucky fluke, the monkey experiment has been repeated every year from 1964 to 2010. The result was that the vast majority of monkey portfolios outperformed the market each year.


Next, look this up:


“How often do fund managers outperform the market over a long term?”


You probably already know where this is going but I'll say it anyway, what you will find is that the majority of fund managers will fail to beat the market. It might be relatively common to find a fund manager who beats the market in the short term by picking a set of stocks for their portfolio and then actively managing it. But if you extend that time frame out to longer periods such as 10 or 15 years the vast majority will under perform overall compared to their benchmarks. And when it comes down to the very few who do outperform, the data indicates that this is actually just down to luck.


These results are not restricted to any particular market either, they are uniformly poor across all markets and categories and this is consistent over a period of time where studies have been performed. In short, it is hard to beat the market even for the professionals who pour hundreds and thousands of hours into their research, models and predictions.


For the record I'm not just some outsider person who's never worked in a financial institution, I used to be a day trader for a derivatives trading firm. While I was there I sure did like shouting out things like "86s go bid with size in Dec-Dec Brent, anyone hitting those?".


I'd say it with conviction and those aren't just random words, they did mean something to the people working on the trading floor alongside me. Regardless, I or anybody who responded to me literally had no idea what the market would do next.


Here is where this all hurts the most; by entrusting your money to be invested and managed by an active fund manager you will need to pay a regular fee, usually a percentage of your investment value at the time of when the fee is due. Note that this fee is based on the value and not the gains, meaning that win or lose you will have to hand some money over to the fund manager.


The fees you pay towards an actively managed fund are usually quite high, for example in the region of 2%. Remember all the hard work, long hours and complex calculations that the fund manager and their teams need to do?


Somehow that all needs to be paid for and it isn’t cheap. After all if they don’t do it, would you put in the hours yourself?


But from the studies that we looked at earlier there is an implication that all of that hard work is for nothing. Actually it would be better if it was for nothing because that would imply you didn’t lose anything. I’m not building up this argument against active fund managers because of some loss I experienced in the past in my own journey towards financial independence, no such thing ever happened; but what I’m finding is that I can get far better and more consistent results in the long term by just giving a monkey a set of darts, and maybe a banana instead.


Monkeys have beaten the investment portfolio performance of most active fund managers in the long run

In comes the passive index fund, a type of investment that aims to be average. It neither wants to outperform or under perform the market, and simply tries to copy the behaviour of the market in general. If the market rises by 10% the index fund should similarly rise by 10%, if the market falls by 6% so should the index. In the long run what you will get is the same performance as the market itself.


So why do I think being average is good?


Because as we already established, this is better than being like the majority of active fund managers who under perform. And the best part is that there is very little to "manage" in an index fund since the only thing it needs to do is match the composition of the market, and that means the management fees of these funds can be kept low.


This approach may sound unglamorous when you compare it to the wild stories that you might come across about investment banking, Wall street or getting rich in general but that’s exactly what you need (whether you realise it or not). Unglamorous means your money, and therefore part of your wealth, is in a place that can be considered steady and sensible.


If you need more evidence simply look up the following:


Warren Buffett’s 2007 bet against hedge funds


All of the studies, experiments and simulations are well and good but there’s nothing like betting a million dollars against the "experts" to really drive the point home.


So let's work through some calculations to illustrate how the fees being charged by a fund manager of an active fund can have a big impact on your returns; even if the performance is "higher" it doesn't necessarily mean you earn more money compared to a passively managed fund with lower fees. I'll go through two calculations:


  1. Investing £1,000 into a passive index fund that has an annual fee of 0.25%, and the investment earns 7% each year on average.

  2. Investing £1,000 into an actively managed fund that has an annual fee of 2%, and the investment earns 8.5% each year on average.


You’ll notice the difference in annual fees is quite large between passive and active funds, but from my own experience I would consider these annual fees to be quite accurate in representing real examples.


Notice how the investment returns for the actively managed fund is higher than the passive fund. I’ve done this on purpose to illustrate how the higher return compared to your passive fund still results in a poorer performance.


So let's get into it and see what happens to your returns over the next 30 years.


Passive Index Fund


An illustration of the investment growth in a low cost passive index fund

By investing £1,000 and getting a return of 7% each year your initial investment will have grown to a value of £7,061.56 after 30 years, taking into account fees. Here's how you can do the maths yourself:


Starting value: £1,000

Average annual return: 7%

Annual fee: 0.25%


Return in first year: £70

(£1,000 ÷ 100) × 7

Fees owed in year 1: £2.68

(£1,070 ÷ 100) × 0.25

Cumulative fees after 1 year: £2.68


Investment value after fees, after 1 year: £1,067.32

(£1,070 - £2.68)


The above set of calculations get you to the figures for year 1 in the table. From there you can do the following to calculate year 2:


Starting value in second year: £1,067.32


Return in second year: £74.71

(£1,067.32 ÷ 100) × 7

Fees owed in year 2: £2.86

(£1,142.03 ÷ 100) × 0.25

Cumulative fees after 2 years: £5.54

(£2.68 + 2.86)


Investment value after fees, after 2 years: £1,139.17

(£1,142.03 - £2.86)


Continue these calculations for the years that follow and eventually you will get to the results and figures that reveal what will happen after 30 years, as displayed in the table above. What you will find is that a fee of 0.25% annually will result in a total of £240.84 being paid over 30 years, or basically £8.03 each year on average.


Not bad for a total growth of £6,061.56 on top of the £1,000 that was invested at the start, assuming an average growth each year of 7%.


Let's compare this to an actively managed fund that has "better performance" but higher fees, and see what the results turn out to be.


Actively Managed Fund


An illustration of the investment growth and the impacts of the costs in an actively managed investment fund

Just by looking at the bottom row of the table you can immediately see that the investment value of £6,304.85 after 30 years is poorer than that of the passive fund. This is despite the annual return percentage being higher consistently over the entire time frame, 8.5% as opposed to 7%. Again, let's break down the maths so you can see how this works:


Starting value: £1,000

Average annual return: 8.5%

Annual fee: 2%


Return in first year: £85

(£1,000 ÷ 100) × 8.5

Fees owed in year 1: £21.70

(£1,085 ÷ 100) × 2

Cumulative fees after 1 year: £21.70


Investment value after fees, after 1 year: £1,063.30

(£1,085 - £21.70)


At £21.70 you would have almost paid the same amount of fees as 7 years worth of cumulative fees from the passively managed fund (£22.96), just in year 1. Continuing into year 2:


Starting value in second year: £1,063.30


Return in second year: £90.38

(£1,063.30 ÷ 100) × 8.5

Fees owed in year 2: £23.07

(£1,153.68 ÷ 100) × 2

Cumulative fees after 2 years: £44.77

(£21.70 + 23.07)


Investment value after fees, after 2 years: £1,139.17

(£1,142.03 - £2.86)


Hopefully you've got the hang of this calculation and you're able to take it up to 30 years to get to the results displayed in the table above, if you wanted to check the numbers for yourself. Here are the key findings, at a fee of 2% annually it only takes 9 years for the cumulative fee to build up to an amount that is more than what was paid over 30 years for the passive index fund. After the full 30 years the cumulative fees paid towards the fund manager will come to £1,818.56; that's much heftier than the £240.84 paid for a passive index fund.


Now this wouldn't be a problem if the returns for the actively managed fund was actually better than the passive index fund, but the final value after fees stands at £6,304.85 after 30 years. This is despite the average performance of 8.5% being higher than the 7% achieved by the passive index fund. Considering that you only invested £1,000 at the start the fund manager might brag about this performance, and indeed you didn't "lose money", but had you gone down the passive route you would basically have just over £750 more in your pocket. To drive this message home, that would equate to an extra 12% in profits that you get to keep yourself.


Now that being said, you still made over £5,000 in profits from a £1,000 investment so you might hear someone say "if the actively managed fund had a higher average performance then that makes it better than a passive index fund for certain, and the fees would've been worth it".


But here's the nail in the coffin, this actively managed fund example has managed to outperform the market for 30 years straight. So while you might hear people (probably the fund manager) make the above argument, just keep in mind that this consistency in beating the market is extremely unlikely.


You're probably going to end up with one of those fund managers that will under perform the market in the long term instead; not that they would care, since they'll be charging you with those hefty fees all the same. Best to just stick with the monkeys, they'll be much cheaper and they've proven themselves to perform better.


An Approach That Works For Everyone


Towards the start of this article I mentioned that I had gained my knowledge through a mix of reading, research, analysis, experimentation and simply learning from my own mistakes. After sharing a little bit of that knowledge by comparing the passive index fund with an actively managed fund I think it's time to share how I personally go about investing my money.


Here's what I want you to understand and always keep in mind; just because the topic of investing into the financial markets can involve a very wide range of complex concepts, terminologies and strategies it doesn’t mean the same needs to be true for your own approach. By following a very simple, clear and low effort plan you can achieve some phenomenal results over the long term.


Here are the three principles that I follow:


  1. Be consistent: Invest regularly and keep to a fixed schedule.

  2. Be disciplined: Keep it up without any regard for what the market is doing.

  3. Be patient: Stay invested in the market for the long term no matter what happens.


And that's all there is to it, three principles or rules in total; simple, clear and low effort. This is a strategy that can work for everyone provided that they don't try to embellish it with other steps in an attempt to "find an edge", believe me I've tried and I'd wager I'm not alone.


Consistency is all about actively building up your investment value yourself by continuing to invest some amount of your money each week, month, two months or any other schedule that suits you. It doesn't matter what your schedule is as long as you stick to it; never skip a scheduled investment window even if it means you need to invest a bit less for that occasion. Extremely high contributions isn't absolutely necessary for building a big investment pot, so don't worry if you can't invest too much each time. I personally invest the same amount each month when I get my paycheck coming in, and every now and again if I've earned a bit extra through commissions or bonuses I will invest a little more. It doesn't really matter too much if you're investing the same or different amounts each time, as long as you're investing something (it's better than not investing anything).


Discipline means you will never let the market's recent behaviour affect your plan or your schedule, no matter what. As soon as your monthly or regular income comes in you will make sure that investing a portion of that money is among the first things you do, if not the very first. And you will invest your money as per the schedule regardless of if you feel the market is too high, or if it is falling too quickly. I'll cover some scenarios on this later in the article.


Patience means you are in this for the long run and you will keep your money invested into the financial markets regardless of what happens. In all of my examples and diagrams (for this article or any others) you will notice that I play out the calculations for a number of decades, and it is in the later years where the gains and results are really pronounced. You’re hopefully going to be living for that amount of time anyway, so you might as well stick with the plan all the way through to the end.


If you stick to these three principles you will most likely see some strong results over the long run. This is regardless of the amount you might be investing regularly, which platform you use and which fund you invest into (provided it is a low cost index tracker). Even if you experience one or more market crashes along the way you'll still do well as long as you stick to the plan. It's reasonable to be concerned about those market crashes and if you're in for the long run you will inevitably experience one or more of those, but trust me when I say it's really not as bad as it sounds; it's a big topic though so I'll have to cover it in a separate article in the future (subscribe or check back in the future!).


The Market Timing Trap


One of the common mistakes when it comes to investing is trying to "time the market", and getting caught in a really difficult spot because of it. It doesn't matter what the situation might be, rise or fall, if you find yourself waiting for a "better price" to get in then you're likely going to get into trouble sooner or later. Even if you manage to pull it off a few times correctly you'll eventually find that it was more down to luck rather than skill.


You'll remember I mentioned this earlier when I wrote about being disciplined, but I figured that writing a little bit more detail to help you think through the process will help you realise that "waiting for a better price" is probably not going to be worth it.


Here's how things are likely to play out; if the market has risen up in the days, weeks or months just before you make your regular investment, you might be tempted to wait and see if it will drop back down a little bit to get a cheaper price.


"It can't keep going up forever and has to come back down a little at this point" is what you might say to yourself, believing that the continual rise certainly means a pullback is imminent.


Inversely, if the market has been dropping you might be worried that it will continue to go down meaning you will lose money on what you buy. You might be tempted again to wait and see if you can get a cheaper price after it drops further.


"Since it's dropping so much I might as well wait for the bottom so I can get in at the best price" is probably what you'll think, despite the obvious disparity from the thoughts earlier when the market was rising. In one pattern you expect the trend to suddenly reverse, in the other you expect it to continue, with no real basis for either conclusion.


A diagram showing the trap of trying to time the market regardless of if it is rising or falling in price

Essentially you're just trying to get more bang for your buck and ultimately more profits for when the price goes back up. But the problem with trying to "time the market" in this manner is that it will cause all sorts of psychological problems and difficult decisions when things don’t unfold the way you imagine. This quickly becomes an extremely undisciplined approach that could actually damage your progress overall.


Chasing The Market Upwards


Think about this scenario; if the market has been rising and you wait because you think it might drop back down a little bit, what would you do if it just keeps going up?


I can tell you because I’ve been in this situation and I’ve made this mistake more than once. You will tell yourself that if it goes past a certain point on the way up you will simply buy it no matter what, so you don't miss out on any more profits and you can catch the rest of the ride up. But in reality when it reaches that point where you promised yourself you would buy, you will simply do the same as before and wait to see if it drops a little to give you a chance to get it cheaper.


This puts you in a bad cycle where the price continues to rise but you have not bought it, meaning you are missing out on all of the gains. Eventually you might simply decide not to buy it this time around (i.e. this month) as the price has become too high, meaning you have broken the first principle of the plan since you are no longer consistent.


Alternatively, you do buy it at whatever price you can get after it has kept rising but this essentially means you are panic buying and you won't feel good about what you bought since you will still be kicking yourself that you didn't get in earlier.


There’s only two real outcomes once this happens; the price will continue to rise and you will wish you simply followed the plan to be disciplined at the start because that means you’d have bought it cheaper, or the price will start to fall and you will feel all sorts of emotional and psychological frustration since the market finally decided to do its pullback after you've gotten in.


In this state of mind it is much more difficult to follow the principle of being patient and look at the long term, since you will feel an internal pressure and unease in your actions. You've put yourself into a place where you might make further mistakes and that could cost you overall.


Trying To Catch The Falling Knife


The inverse scenario to the above is if the price actually drops like you were hoping at the start, but you still won’t buy it. You will start to think that since the price is dropping anyway you might as well wait and see how far it goes. That way, you think you can get a better price than you would now and that means more returns when it goes back up.


As the price drops you will feel good about your choice because you aren’t losing money on the money you would have invested. But eventually the price will start to go up.


At this point you would hesitate because you don’t know if this is a temporary rise before the market continues to fall, and you’re afraid to be fooled by it. But you also don’t want to miss out on the rise because that is what you were waiting for. So you tell yourself that if it rises past a certain point you will decide to buy it.


Guess what, you’re simply back in the first scenario where you're chasing the market upwards.


I’ve been in both situations and made the mistakes so I can tell you for certain, it’s easier and much less mentally exhausting if you ignore what the market has been doing and simply stay disciplined.


Final Scribbles


At the end of the day the popular suggestions that you hear from the broader financial independence community didn't become what it was by random chance. There are countless different options, strategies and opinions out there when it comes to investing your money and growing your wealth, but the ones that are proven to be consistently successful are few and far between.


You either have to find a super star fund manager who outperforms the market by a considerable margin and maintains that for multiple decades, or you could just follow the market in its entirety by buying a passive index fund and have an average performance that is actually "above average" in comparison to the results of most actively managed funds.


In simpler terms, you could try to find the needle in a really large haystack or you could just take the entire haystack with the needle in it. Which seems easier to you?


Also, don't forget you actually need to find the needle in the first place which could take a considerable amount of time. And the worst thing is that sometimes you might "find a needle" but you won't know if it's actually any good until the end. A fund manager may start off with promising results and they might even have an impressive history, but since past performance cannot be used to guarantee future returns you will never know if those results will be maintained during your time until it has actually happened.


If it turns out at the very end that the impressive results towards the start was just down to luck, it'll probably be too late for you to recover from it. Not that the fund manager would really care, they already got their fees from you and that's all that really mattered to them (think about that for a moment).


The only person who would truly care about your wealth in the long run is really just yourself if you think about it pragmatically, so the best person to trust with managing your wealth is... you.


Now you might be concerned about your lack of experience and knowledge but don't be intimidated by the financial markets; much of the complexity is fabricated by those who stand to benefit from your lack of self involvement.


Stick to a simple yet effective plan that is focused on really clear principles and you will most likely fare quite well in the long run, probably even better than many professional fund managers. Always take the thought process "out" of things by using the principles as your "guiding compass" on what to do next, as it is tried and tested not just by yourself but numerous others in the search for financial independence. If you keep the thought process "in" then you might find yourself getting stuck in a difficult cycle where you are either chasing the market upwards or trying to catch a falling knife.


Smarter people than you or I, who have been referred to as the "greatest investors of all time" have claimed that even they cannot tell what the market will do next. That's enough for me to not bother trying myself, and I think it's wise if you take the same view also.

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For me, the purpose of financial independence is to regain control of my personal time rather than needing to spend it in work. Money is just a means to get there and not the end goal itself. In writing this blog I hope to use my own experiences to help others find their reason on why they want to reach FIRE.

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Thanks for reading!

Kujah

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