Index Funds = Best 401k Investment Portfolio Strategy
You get what you pay for is one of those age-old cliches that has a lot of wisdom for daily living built into it. Generally, it's a good principle to bear in mind when paying for goods or services - except, that is, when it comes to investment management services!
A new study by a couple of high-powered finance professors comes down squarely on the side of low-cost index funds as the best 401k investment portfolio strategy. Running thousands of simulations using actual returns (1984-2006) on more than 3,000 actively-managed mutual funds, the authors find that active "fund managers do not have enough skill to produce risk-adjusted expected returns that cover their costs."
In other words, choose to pay high fees to get professional active investment management services and you are almost certain to end up worse off than if you had invested in passively-managed low-cost index funds. 1
High investment management fees are one of the more insidious threats that 401k investors face. The following graph shows how a 1% higher fee can erode the value of a 401k account:
Avoid the high fees associated with active investment management. Research shows you'll almost certainly do better with low-cost index mutual funds.
Unfortunately, tons of money are thrown into marketing actively-managed funds to 401k investors. In many cases, 401k participants are not sophisticated investors and follow the marketer's pitch. It is incumbent upon 401k account holders to ask questions about fees and performance. For most 401k investors, the guiding principle should be "you don't always get what you pay for - stick with low cost index funds."
Notes:
- An index fund is constructed to match the components of a market index like the S&P 500 or Wilshire 5000. Because index funds do not rely on professional managers to "pick" investments, fund expenses are kept low. [↩]
