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3 Reasons to Dump Your Mutual Funds for Index Funds

Do you currently have money in a 401(k) or 403(b)? If so, most of your hard-earned dollars are probably invested in mutual funds. As a rule of thumb, investing your money in a mutual fund is better than stashing all of your cash in a single stock or bond. After all, it’s better to diversify your investments to reduce your risk, which is why mutual funds aren’t an awful investment, but I believe they aren’t the best investment.

About a year ago, I met Andrew Hallam, a mid-30 year old millionaire that did not acquire his wealth with a high-paying job or a glamorous business venture. Nope, he’s making his millions with index funds on a teacher’s salary. I read his book, “Millionaire Teacher” and I was immediately convinced that Index Funds were the way to go with my investments as well. Over the course of 2012, my index fund investments have averaged over 14% growth.

Mutual Funds – the not so great investment

Like I said in the first paragraph, mutual funds are definitely safer than piling all of your money in one stock, but there are many reasons why you might want to shy away from these investments. Let’s quickly dig into these reasons.

1) High Fees

Mutual Funds are a conglomerate of many stocks of the same nature. There are mutual funds for restaurants, real estate, crude oil, tech companies – pretty much anything you can think of. They’re good because by owning a small share of many companies, your investment becomes safer. They’re bad because there are many employees of this mutual fund that are paid to try and beat the market. And, who do you think pays for these employee’s salaries and the building they’re working in? You do! with your 1.5% fees that you pay on your investment account each year, you are keeping this mutual fund in business. And, whether you realize it or not, these fees are eating up your investment profits!

2) Broker Fees

Many of you have Financial Advisors that help you invest for the future. Did you know that these advisors/brokers get paid from mutual fund companies to push their investment fund? It’s in your advisors best interest not to make you a bunch of money for your future, but to push a product (the mutual fund) that pays the most into their own pocket. On top of that, you are paying your broker a fee each year to handle your investment accounts for you, even if you lose money.

3) Sub-par performance

Many Mutual Funds believe they can beat the market. Some do for a short period of time, but overall, it has been confirmed (by Andrew Hallam in fact) that over the long haul, Index Funds have outperformed Mutual Funds. So, if you are investing in Mutual Funds, you are actually earning less money per year, and you’re paying a higher fee!

So What Are Index Funds?

Just like Mutual Funds, Index Funds are a conglomerate of different stocks, but instead of having a team of employees trying to beat the market, Index Funds are set up to mimic a specific index, like the S&P 500, the Nasdaq, or the Dow Jones Industrial Average. Since they aren’t managed every second of the day, they have extremely low fees (like 0.09% instead of 1.2% in a common mutual fund). Also, they are much simpler to understand and purchase, which means that there’s no need for a broker (eliminate the broker fee). And, as I just stated, they have historically earned more than the average mutual fund! All signs point toward Index Funds for me, how about you?

Mutual Funds vs. Index Funds For The Long Term

The fees of 1.2% just seem so small don’t they? Is there really that much difference between paying 1.2% for a mutual fund vs. 0.09% for an index fund? Let’s test out an example and find out!

Let’s assume that you’re 35 years old and plan on retiring when you’re 65. You’ve already acquired $100,000 in your retirement account and have just decided to let the interest earn you the rest of your income until your retirement years. If you put your money into a mutual fund that earns an average of 14% each year, and has a fee of 1.2%, how much will you have after 30 years?

Mutual Fund Results – $4.6 million

Index Fund Results – $6.3 million

Now, let’s say your index fund investment equals the mutual fund’s (even though it’s historically more) at 14%. With a fee of only 0.09%, let’s see how much you’ll earn over the course of 30 years compared to the $4.6 million in the mutual fund.

The results are in. That seemingly miniscule percentage difference impacted your retirement fund in a huge way! I mean $1.7 million huge! If I had the choice between $4.6 million and $6.3 million, I’d take the $6.3 million. Wouldn’t you? I suggest that you take a serious look at your retirement accounts and see if index funds are right for you!

What do you think about Index Funds vs. Mutual Funds?

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14 comments to 3 Reasons to Dump Your Mutual Funds for Index Funds

  • I am a bit confused. If you are truly talking about index funds as opposed to Exchange Traded Funds, then index funds are mutual funds. Perhaps you may wish to reconsider your use of terms when you discuss index mutual funds vs. actively managed mutual funds.

    Additionally, early in your article to state, “Over the course of 2012, my index fund investments have averaged over 14% growth” as if this is proof of the value on one investment philosophy vs. that of another. IMO less than one year does not provide much of any confirmation nor criteria in regards to performance.

    Cheers.

    • Very true Al. Index Funds are a type of Mutual Fund, but are just not actively managed and therefore have less expenses. To keep things simple, I just didn’t dive into that aspect. And, yes, the fact that I made 14% over one year with Index Funds does not necessarily prove that they are better than actively traded mutual funds, but they did end up earning more, plus I paid less in expenses. Take a look at Andrew’s book if you want more proof on Index Funds. Thanks for the awesome comment! You definitely know your stuff!

  • Dan

    Derek

    Great post for your readers, however, a 14% return is not likely for 30 years. Your scenario would be better assuming a historical average 8-10% return. Would you re-run the numbers for your chart?

    The other way to diversify your holdings through index funds is selection of several index funds and automating your investments on a monthly basis. Vanguard’s website is very easy, and one of the lowest cost index funds available. For an easier diversification solution, put your funds into one of the target year retirement funds – which is actually an index fund of funds. The costs associated with the target fund are actually passed on from the individual funds, so be aware it’s really your choice. The advantage of the target fund is Vanguard will adjust the risk blend as the target date approaches.
    The only lower cost index funds than Vanguard that are available to some, but not all, is the government’s TSP. The TSP program index funds have the lowest management fees available. They also have target retirement year funds. Now with the new Roth TSP, even higher income earners can get tax relief from their earnings as an automated payroll deduction, which is a benefit not available under ROTH IRAs directly. The way to get money into a ROTH IRA is to do a ROTH conversion, but that requires more transactions, more time, more cost, and will likely create a tax obligation at the time of year that one files his/her taxes.

    Happy new year!
    -Dan

    • Hi Dan. Thank your for the awesome comment! The only reason I went with 14% is because that’s what I recently earned this past year, but historical averages often show 12% so it wasn’t that far off. If we figure that we earned 10%, however, then the Index Funds would earn us $1.93 million and the Mutual Funds only earn us $1.39 million, which is still a difference of $540,000! I’d still choose the Index Funds. Thanks again for commenting. Coem back again soon! :)

  • I couldn’t agree more. Thanks for this post. I love the Little Book of Investing (Bogle). After reading it, I put everything in a Vanguard Total Stock Market fund. Couldn’t be happier..
    Tony@YODTO recently posted..Decluttering Your Closet

  • Personally, I would rather use ETFs than any kind of fund. ETFs such as SPY are so much easier to trade than funds. Very informative post!

  • Great advice. I really need to look into the MERs of what I hold and find better alternatives.

    Thanks!
    Alex recently posted..Happy New Year – My plans for 2013

  • Yea, it’s incredible how much fees eat into your yearly gains. I still think Personal Capital has a long way to go towards making their tool an end to end finance solution, however their 401k fee report was pretty eye opening. I didn’t realize how bad things were and it was the nice swift kick in the butt I needed to seriously reduce there.

    My employeer matches my 401k contributions so I have to invest in funds, at least I’ll try and be smart about it!
    Andrew @ Listen Money Matters recently posted..Budgeting for Dummies, the Complete Guide.

  • Thanks for an excellent article. I have a similar article on my blog if readers want to get additional perspective.
    Buy & Hold Blog recently posted..Why ETFs Are Bad For Buy & Hold Passive Investors?

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