Year after year, everyday investors have been throwing away millions – in fact, billions – of pounds.

But now there’s a revolution underway.

FreakonomicsSo says the Freakonomics team in their podcast ‘What’s the stupidest thing you can do with your money’.

The revolution is towards low-cost investing. At Tucana, we agree that it’s the only rational way to go.

Here’s our summary of the podcast.

Say goodbye to stock-picking

The media (and certain canny salespeople) would like to convince you that you could win big by cleverly playing the stock markets.

But the stock markets don’t work like that.

One of our heroes, Jack Bogle, founder of Vanguard (the world’s first index fund), points out: “For every buyer, there is a seller. And for every seller, there is a buyer”.

Ken French, professor of finance at the Tuck School of Business at Dartmouth, explains the negative-sum nature of active investing. “Whatever you win, I lose. Whatever I win, you lose – and we both paid to play that game.”

Together with Eugene Fama, French carried out a study about luck versus skill in mutual fund returns, published in 2010 in The Journal of Finance. They found that only 2% – 3% of active fund managers generated enough extra return to cover their costs.

What’s more, The Wall Street Journal reports: “Between 71% and 93% of US stock mutual funds either closed or failed to beat their closest index funds over the past decade.”

The average cost of owning a mutual fund is 2%.

So maybe it’s not worth paying active investment experts for their so-called expertise?

Instead, you can invest passively in a small piece of the entire stock market through a low-cost index fund or exchange-traded fund (EFT).

Vive la révolution!

Index funds diversify the risk of individual investments.

According to the podcast, $2 trillion of investor money is now flowing into index funds, with a quarter of this amount coming out of active funds. That’s why it’s being called a revolution.

Vanguard was founded in 1975, and are now the leaders in low-cost investing, with $4 trillion funds under management.

By the way, Vanguard is a cooperative that’s owned by the fund’s shareholders. Instead of distributing profits, it lowers the fees.

Probably the world’s most famous active investor, Warren Buffet (heard of him?), even thinks a statue should be erected to Jack Bogle, in honour of what he’s done for investors.

Jack Bogle is now 88, and has been interested in the sector for a looooong time. In his 1951 thesis on the mutual fund industry, he concluded: “Mutual funds can make no claim to superiority over the market averages.”

In summary, stock pickers might like to think they are better than the market – but they aren’t. As an investor, it therefore makes sense to buy into the whole market instead. It’s a whole lot cheaper and more likely to make you money.

Rather than spending, say, £10,000 to buy five different mutual funds made up of hand-selected stocks, you spend it all on one fund that simply tracks an entire stock index. It’s a lot cheaper than buying separate, actively-managed funds, and is likely to perform better as well.

Low fund costs make all the difference.

Over 50 years, a pound invested at 7% grows to around £32 and a pound invested at 5% grows to about £10.

And if that doesn’t convince you to follow Tucana’s scientific approach to investing, then nothing will!

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