Do you ever wonder what it’s like to be a smart investor? Chances are that you do; most Canadians own investments that underperform the market. If a financial advisor says that they know when to buy gold, they may be perceived as smart, and their clients will likely listen to them. The ability to predict is associated with investing intelligence. This approach to investing is known as active management – figuring out which stocks or assets will do well, or knowing when to get in and out of the market. As intelligent as it may seem, there is no evidence to support its efficacy.
Most Canadians own mutual funds, and pay over 2% per year to have their mutual fund assets actively managed. The idea behind that fee is that the fund manager will be able to outperform a benchmark index; it makes sense to pay a higher fee for better performance. This would be great if mutual fund managers delivered above-benchmark returns, but year after year the data on mutual fund performance is disappointing. Most funds underperform over any given time period. What about the good funds? Unfortunately, funds that have done well in the past are no more likely to do well in the future. Stock prices move randomly based on the development of new information. No amount of analysis or intelligence can predict randomness. If knowing when to buy gold doesn’t make you a smart investor, how does anyone do well with investing?
Luckily, there is an investment strategy that some of the smartest people in the world agree on. Four winners of the Nobel Prize in Economic Sciences, and Warren Buffett, one of the most successful and well-known investors in history, are proponents of investing in low-cost index funds. An index fund passively owns all of the stocks that represent a market, for a fraction of the typical 2% cost of a mutual fund. Being smart by avoiding prediction altogether, and eliminating the high fees and commissions associated with trying to make the right calls, has proven over time to deliver excellent results.
One of the greatest challenges for Canadians is that, in general, those providing financial advice do not have an incentive to recommend index funds. Unlike actively managed mutual funds, index funds do not pay commissions. When many financial advisors earn their income based on commission, asking them what they think about index funds is like asking the butcher if you should eat salad for dinner. Try as your financial advisor might, there is no way to refute the evidence. The simple investment strategy of owning low-cost index funds is the smartest thing that you can do with your money.