Friday, January 11, 2008

“Building Wealth” Book Review Part 3

In this third part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth,” we look at his views on market indices and index funds. This review began here.

A market index is a measure of how the stock market performed as a whole. In a sense, it tells you how well the average investor has fared (not counting taxes, commissions, and other fees). You can choose to get the market average performance by investing in a low cost index fund (look here for more information about index funds).

Edelman says that you shouldn’t measure your returns against market indices. This seems like a bad idea to me. If you do better or worse than an index in a given year, it doesn’t mean much, but if you do worse than the index over a long period of time, you need to examine your investing approach and consider switching to index funds.

The discussion of index funds begins with Edelman saying that he doesn’t care if you buy an index fund or an actively-managed fund. This was pretty funny because he followed it with an extended diatribe against index funds, making numerous claims about mutual funds beating index funds over various time intervals. However, his claims are contradicted by the data. For one study that contradicts most of Edelman’s claims, see pages 260-263 of Burton Malkiel’s book, “A Random Walk Down Wall Street,” and see this essay for more detail on mutual fund underperformance.

Edelman’s firm sells mutual funds, and the majority of funds give lower returns than the overall stock market over the long term because of the mutual fund fees that investors pay. Low-cost index funds don’t pay these fees to financial advisors. If investors started comparing their returns to market indices, financial advisors would have a lot of explaining to do.

Asking you not to look at market indices is a bit like asking you not to compare prices on a big screen TV. This might work well for a store that sells TVs at inflated prices, but you are better off if you check prices at other retailers.

In part 4 of this review, we look at Edelman’s views on investment fees.

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