The Biggest LIE About Index Investing

alright so there's a lot of things that have been said about index or passive investing over the years but in my personal opinion there's one thing that stands out amongst the rest is probably the biggest lie or at least the most misleading statement about index investing and that's that investing money in an index is only ever going to produce average returns because you're only ever going to match the performance of the market today we'll be going over how this average return myth came to be accepted as more or less fact as well as going over the data that proves just how incredibly misleading this idea actually is let's get started but before we get going be sure to like this video if you haven't already as it really does help out the channel a lot and subscribe with notifications on for more money related videos like this one every single week and if you want to further support this channel you can check out some of the links I've left in the description below which includes a link to the investing platform m1 finance get started investing for free today so why do we believe that investing in index funds such as the S&P 500 will produce average returns in comparison to other investments well the first and probably biggest reason is that it's just been said so much and by so many people that we just tend to accept it as fact that's pretty easy to do if you don't have the actual data in front of you to check out for yourself it's part of the reason I'm doing this video so we can discuss the data we have and if you want to check it out for yourself I'll leave a link to Morningstar's reports in the description below this video the second reason is that there certainly are investments that do help perform benchmark index funds like those that follow the S&P 500 each and every year it's not exactly common for a single investment to outperform the index over long periods of time but it is possible the third reason is that it's good for business let's face it less of us would be using financial advisors to help us pick stocks if we knew that the vast majority of them failed to even match benchmark index funds which is unfortunate because a good financial advisor can still be well worth the money for a lot of people even if they don't beat their index fund they can be teachers giving you ideas on how to manage your money beyond just which stock or mutual fund to pick they can talk you off the ledge when things are going bad and you're considering selling your investments during a market crash because let's face it the behavior gap is very real and if an advisor manages to steady you in the heat of a crash even once they may very well have more than made up for their costs right there so this video is not meant to be a shot at financial advisors or stock pickers or anything like that it's just meant to clear up some misunderstandings surrounding index funds and other passive investments but with that being said what does the actual data say about the performance of investing in index funds compared to more actively managed funds or even investments outside of the stock market let's take a look and find out ourselves so today's data is coming from Morningstar semiannual active-passive barometer report for August of 2019 because at least at the time I'm writing the script that's the most recent version of the report that's been released the report covers all the data through June of 2019 this report measures the performance of u.s. active managers of some 4,000 funds against their passive peers within their respective categories the categories include large mid and small cap stocks which are further broken down into value growth or blended funds various foreign and international investments real estate both in the US and worldwide and of course bonds if passively managed funds are really producing average returns we would expect to see that actively managed funds managed to outperform them somewhere in the neighborhood of 50 percent of the time but that often isn't what happens over the course of the last year active managers of large cap stocks outperform their passive peers a little over 30% of the time with managers of growth stocks doing the best growth stocks actually outperformed 54% of the time which is in the ballpark of what we should be expecting but value stocks outperform just 34% of time and blended funds only outperformed 32% at the time if we look back a little further we see that these success rates fall pretty much across the board over the last three years growth stocks still did the best but only outperformed the passive funds 38% of the time value and blended funds outperformed 33% and twenty nine percent of the time respectively and this story continues over a five-year span with growth stocks still outperforming their passive peers 30% of the time but value and blended funds fell significantly with their success rates dropping down to fifteen and three tene percent respectively and over the last ten years the success rates of these actively managed funds cratered to their lowest levels growth and blended phones outperform their passive peers a mere eight percent of the time with value funds doing even worse than that with a success rate of just seven percent since 2009 now these success rates do rise a bit in the last 15 year stretch and the 20-year stretch with active managers outperforming their passive peers about 15 percent of the time in the case of this particular report but even so 15 percent of the time is not where we would expect to see them if passively managed index funds produced average returns now I know what some of you are thinking well that's just the large cap space it's harder for active managers to outperform index funds there because almost all of those companies are pretty well known it's tougher to find a diamond in the rough company that everyone else is overlooking in that space that will allow an active manager to outperform their index and if we just look at the other areas of the market that are less thoroughly covered we'd see a different story being told by the numbers and there is some truth to that so let's start by looking at mid cap stocks actively managed portfolios in the mid cap space did have higher success rates on average than their large cap counterparts over the course the last year mid cap growth stocks succeeded in outperforming their passive counterparts a whopping 79% of the time which is way more than we would expect to see blended funds outperform 46% of the time which is about what we would expect to see and value funds succeeded just 32% of the time which is less than we would expect to see but hey all in all fairly good over the course of three years growth funds were still kicking butt with success rates of 59% value funds were hovering at around a 33 percent success rate and blended funds saw a fairly significant drop from their one-year score outperforming their passive peers just 26 percent of the time over the course of five years we start to see a similar story taking place as we saw in the large cap space growth stocks were admittedly still doing quite well with success rates of 54 percent over the course of those five years but the success rates of blended and value funds continued to underperform what our expectations would be blended funds succeed now performing there pass appears just 14% of the time and value funds just 24% of the time and unfortunately for active investors in the Mid Cap space the buck stopped when we looked at the data for the last ten years growth stocks finally fell out of favor compared to their passively managed counterparts outperforming them just twenty nine percent of the time value funds fell to a success rate of 11% and blended funds did even worse scoring victories over passive funds in just 7% of the recorded cases similar to large cap funds the 15 and 20 year time periods were an improvement on the ten-year span but none of the fun categories managed to have a success rate of even 30 percent in either time frame which again is way below what we would expect to see if index funds produced average returns small cap funds had a similar story to the mid cap space growth funds had success rates of 75 percent over one year 61 percent over three years 52 percent over five years 35 percent over ten years and 25 percent over 15 years value funds succeeded 45 percent of the time over 1 year 44 percent of the time over 3 years 39 percent of the time over 5 and 10-year periods and 25 percent of the time over 15 year periods and blended funds produced superior performance 45 percent of the time during the last year 29 percent of the time during the last three years 26 percent of the time during the last five years 22 percent of the time over the last 10 years and 19 percent of the time over the last 15 years so now you may be asking yourself okay so at least based on the historical data that we currently have here passive funds have more often than not beaten their actively managed counterparts especially over longer periods of time but does that hold true overseas or even in investments outside of the stock market such as those in bonds or real estate and the answer is it depends for instance the actively managed foreign investments covered by Morningstar's report almost never outperformed their passive counterparts and in fact they rarely even came close to achieving success rates of at least 50 percent worldwide large cap stocks outperform their passive benchmarks about 55 percent of the time over the course of the last year but that success rate fell to 46 percent of the time over three years and continued dropping steadily from there the emerging market space managed to beat their passive benchmarks about 55% of the time over five-year periods and 49% of the time over 10-year periods which is very impressive however they have been struggling more recently with success rates of just 34% and 43% over 1 and 3-year periods so we'll have to see if that clears itself up as time goes along real estate did impressively well over the last year with us-based real estate outperforming their benchmark 56 percent of the time and global real estate posting success rates of 76 percent over the same time frame however the numbers did fall pretty quickly when we looked at longer time frames with success rates for both us and global real estate hovering around 30 to 35 percent in most cases bonds actually probably had the strongest showing in this entire analysis with the corporate and high-yield junk bonds posting success rates of close to or even over 50% in the majority of cases but of course that's measuring their success rates against various passive bond index funds and not real estate or stock funds and I only mention that because this video is trying to figure out whether passive investments and in particular the popular ones like the S&P 500 index funds actually produce average returns and of the categories measured in this report bonds often had close to the lowest overall returns while stocks had among the highest as you would expect so while holding an actively managed bond fund that gets you 6% a year in returns is great especially when the passive bond fund only gains you 5% per year it is worth considering that during that same time period a large cap stock fund such as an S&P 500 index fund might have netted you 16% returns and I'm not throwing those numbers out for no reason that's actually the difference between the returns of the corporate bond fund and the large cap growth funds in this report corporate bonds according to this report had average returns of 6% per year over a 10-year period large cap passively managed growth stock funds averaged over 16 percent per year hypothetically if you had invested $500 a month into the corporate bond funds over those ten years you'd have a net worth of about eighty one thousand six hundred dollars today not bad if you had invested in the stocks your net worth would be almost a hundred and thirty nine thousand that's a difference of over fifty seven thousand dollars over the course of ten years or in other words almost the entirety of your out-of-pocket investments during that time now obviously that is a little unfair to the bonds because the last ten years that this report was covering was 2009 to 2019 when stocks were on a long bull run but stocks have historically outperformed bonds over the long haul so while this particular instance is a little bit ridiculous the idea still is worth considering some asset classes just have historically done better than others but that does bring up an important question on average how did the returns of actively managed funds compared with those of passively managed funds because it is possible that the best actively managed funds perform so incredibly well in comparison to the passive funds that are expected returns from choosing a variety of active funds would be higher than if we had chosen passive funds even if we know that most actively managed funds fail to beat their passive counterparts that may sound a little confusing so here's how this would work say that we have three active funds and three passive funds to choose from the active funds will call a B and C just to keep things simple the passive funds will be XY and Z we don't know what the future returns of each of these funds will be so we decide to spread our investments over all three of the actively managed funds equally we invest $100 a month in each of the three funds and we do it for 10 years fund a ends up with an average return of 5% per year fund B produces returns of 8% per year fun C ends up being the big winner with average returns of 20% per year after all expenses and fees are accounted for and for the sake of simplicity we'll say that all three passively managed funds had returns of 10% per year this means that fund a and fun B failed to beat their passively managed counterpart but how does the value of our investments compare at the 10-year mark in our hypothetical case the actively managed portfolio would be worth about $72,000 while our passively managed portfolio would be worth about 62,000 pretty sweet huh we warned with actively managed funds despite fighting what seemed to be a losing battle but is this how the data suggests it actually works in real life well as it turns out no at least not over the long term the report admittedly only gives the return figures each category for the last ten year time frame but the difference between the average actively managed and passively managed returns were stark enough that I felt it was worth discussing because especially in the stock market there can be quite a difference and it's usually in favor of passively managed funds on average large cap stock funds showed the biggest difference with passive funds outperforming the active funds by over 2% per year surprisingly growth funds showed the biggest difference even though that was where we saw the largest percentage of active funds succeed actively managed large cap growth funds average returns of about 14% per year over the 10 year time frame measured by the report while the passively managed funds averaged a whopping 16 point 4 percent per year Mitton small cap funds saw similar albeit smaller differences with passive funds winning by around 1% and one and a half percent per year on average the foreign international real estate and bond categories were all pretty darn close to a wash in terms of returns achieved but it is still worth noting that the average returns of the foreign international real estate and bond investments were all dwarfed by the returns achieved by stocks average returns for the actively managed foreign in international investments were 7% per year for real estate it was about 12% and bonds about 6% compare that to the near 15% average returns for passively managed large cap stock funds like the S&P 500 index over this time and its returns look anything but ordinary but that'll do it for me today once again if you enjoyed this video be sure to smash that like button if you haven't already subscribe and hit that bell next my name's you'll be notified of all my future uploads I generally upload every single Monday and if you have a friend that would be interested in this kind of content be sure to share it with them let's really get this information out there and start our own financial revolution

Channel: Next Level Life

Views: 81,161

Rating: 4.8045826 out of 5

Keywords: financial education, money, next level life, personal finance, investing, debt, financial freedom, financial independence, budgeting, retirement, early retirement, retire early, ryan scribner, financial diet, finance, stock market, stocks, graham stephan, index investing, the biggest lie about index investing, the biggest lie told about index funds, investing myths, investing lies

Id: 4taIFw6e04c

Length: 15min 8sec (908 seconds)

Published: Mon Apr 27 2020