You Wall Street tool, you

Whether you have $1,000 or $1 million in a mutual fund, you're a capitalist, Brett Arends writes in the Wall Street Journal. You're providing America's risk capital.

So how does Wall Street treat you?

To the barricades, I say!

According to Morningstar, the average money manager skims fees of 1.4% a year from your stock fund, and 1% from your bond fund. 

It may not sound like much, but it is. Especially these days, when returns are so low anyway.

Look at the cost over time. Consider someone who invested $1,000 every year for the past 30 years in a balanced portfolio of 60% U.S. stocks and 40% bonds. Today, after paying fees, he or she would have about $105,000. 

Sound good? Without those fees they'd have $137,000. Wall Street effectively pocketed the other $32,000. 

The picture is even starker than it looks. After all, you could have ended up with $54,000 just by keeping your money in risk-free Treasury bills. 

So your reward for risking your capital was a more modest $51,000. It should have been $83,000. But Wall Street pocketed nearly 40% of your return. 

Furthermore, the true picture on costs is surely much higher. Fees used to be even higher than today. And we're not even counting the extra hidden cost of trading expenses. 

Wall Street claims "management fees" are the price you pay for having them manage your risks. How'd that work out? In the 2008 crash, the average "actively managed" mutual fund actually did worse than an index fund. So much for that.

I'm gonna head down to Wall Street and camp out in the park and get free food and urinate on a shrub.

Why it's hard to pick a winning fund

No longer needs a mutual fund.

Ted Cadsby, a consultant who used to run a mutual fund company, uses mutual funds to point up a problem in our thinking.

Why are there so many funds? If one got it right all the time, there would be no need for others. The others are kept in business because of the way we think.

The problem lies in how our minds are geared to underestimate the role of randomness in our lives — the profound but hidden influence of the uncontrollable and unpredictable.

Here's the root of the problem: To pick a winning fund, you need to identify information signals that are buried in a lot of random noise. Three layers of noise, in fact: noise in the company's reported results that make its stock value hard to assess; noise in the manager's track record that obscures skill; and noise in the stock market that conceals the conditions under which the manager's particular stock-picking style is effective.

A whole industry is based on the assumption that relevant signals pointing to a good fund can be screened from all this noise, Cadsby says.

The precariousness of this assumption is revealed by all the "winning" funds that eventually underperform. And the size of the industry is testament to just how prone we are to overinterpret meaningless, random noise (e.g., luck) by reading patterns (e.g., skill) into it and thereby misinterpreting complexity (e.g., "Ten years of outperformance can't come from luck alone so this fund is a good investment").

So what's this got to do with being eaten by a tiger?

We are naturally predisposed to overinterpret because we assume that virtually everything we perceive has inherent meaning. We do so because the risk of underinterpreting (known as a Type II error) is greater than the risk of overinterpreting (a Type I error). Say you're walking in a forest and hear the crack of a twig behind you. You can play it safe by assuming you're being stalked — thereby avoiding a Type II error while making yourself vulnerable to a Type I error. Or you can assume the sound was just caused by random rustling of the wind — thereby avoiding Type I error at the risk of being eaten. From a survival point of view, it's better to be inconvenienced by a Type I false alarm than killed by a Type II missed threat; i.e., better to overinterpret than underinterpret.

Suppose I'm not in the market or a jungle. So what?

Consider some "random" examples. Relationships of every kind are riddled with overinterpreted noise. How many angry exchanges are triggered by extraneous comments or fleeting looks, many of which are attributable to passing moods? By understanding that random expressions of irritation are often not obscuring important signals, we can do a better job of ignoring them, making for much smoother interactions — especially at home!

Here's the lesson.

When randomness runs deep, our best strategy is sometimes to simply accommodate it, as in the proven strategy of investing in index funds that buy all stocks as opposed to trying to pick the "best" ones. Granted, anything that feels remotely akin to surrendering to randomness is hard for us: Our deep-seated need to feel in control motivates us to read something into nothing.

That's my advice to readers of this blog: don't read something into nothing.

A managed fund beats an index

I noted the other day that some research had given the nod to index funds over managed funds, the difference largely being the index funds' lower fees.

A few years ago, however, I switched from mostly index funds at Vanguard to mostly American Funds, a company whose funds are sold only through brokers and that can carry hefty up-front fees (loads). I have been quite pleased with American Funds through the recent ups and downs of the market.

One of the selling points for me was a diagram showing that American could beat indexed funds if they were regularly rebalanced. Now I've come across a study by the blog AllFinancialMatters suggesting the same thing.

Blogger "JLP" -- I wish people would use their full names -- compared the S&P 500 against American's Investment Company of America fund for a 10-year period.

The value of the ICA (Class A) shares (after the 4.5% front load) was $122,257 at the end of 2009 while the value of the Vanguard S&P 500 Index Fund shares was $90,165. That’s a $32,000 difference. Had the ICA shares not had the front load, the end value would have been over $128,000. Here's a chart:

Now before you run off and put all your money into American Funds, read the full piece to get the assumptions and caveats, and also read the comments to hear some criticism. It may all be due to the period he chose to compare. Nonetheless, it's interesting.

The low-cost funds win again

John Bogle, the founder and former chief executive of the Vanguard Group, is the chief evangelist for index funds, those that hold the same stocks and don't do active buying and selling. Because they don't need fund managers -- they're managed by computers -- index funds charge lower fees.

And those fees add up. Bogle points to yet another study to prove his point.

A recent study by the Morningstar fund evaluation service came to this very same conclusion. In an admirable report that was the opposite of self-serving, Morningstar found that using fund-expenses ratios as a factor in choosing mutual funds was even more helpful than relying on its own carefully constructed "star ratings." Specifically, focusing on funds with the lowest expense ratio was more helpful in fully 58% of the time periods studied.

"In every asset class (U.S. stock funds, international stock funds, balanced funds, taxable bonds, and municipal bonds) over every time period," Morningstar wrote, "the cheapest quintile produced higher net returns than the most expensive quintile." Among domestic equity funds, the returns of the lower-cost funds outpaced the returns of the higher-cost funds by about 1.3 percentage points annually. That proves to be a compelling edge. Over a 50-year investment lifetime, for example, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.

The idea that costs matter is not new, Bogle writes. In a 1966 article in the Journal of Management, economist William F. Sharpe concluded, "all other things being equal, the smaller a fund's expense ratio, the better results obtained by its stock holders."