Peter Lynch Warns About the BIG Danger of Index Funds in Recent Interview (2021)

If you've been following this channel, you know Peter Lynch is one of my favorite investors to study. However, Peter Lynch hasn't given an interview in years. So when he finally gave an interview this past week, it got my full attention.

In this interview, Lynch says that investors who only invest in passive index funds are "missing the boat" and are essentially costing themselves for making more money. In this video, we are going to analyze these comments and see if Lynch is truly correct. We're also going to make sure you're not leaving any money on the table with your own investing strategy. Now, let's jump right in.

Indexing is a form of passive investing. Unlike passive investing, Peter Lynch managed an active fund, the Fidelity Magellan Fund, where he actively picked stocks, how much of them to buy, and when to sell them. An index fund, on the other hand, spreads your investment dollars across a wide selection of stocks that matches a particular index. The most common index is the S&P 500. So if you invest in an S&P 500 index fund, your money is spread out among all the companies that make up the S&P 500.

The companies that make up the S&P 500 are essentially the 500 largest publicly traded American companies. With an index fund, instead of a portfolio manager trying to pick the stocks that will go up the most and avoid the ones that will go down in price, you are essentially saying that you know some of the 500 companies will have bad returns and maybe even go to zero. But on the other hand, there will be companies that will have great returns, maybe 10x or 100x. Combined, your results will be pretty good, as your returns will essentially be the average of the stock market.

The biggest draws to why people like index funds are because of their low fees. Fees for index funds have become extremely low. To show this, let's take a look at one of the most popular S&P 500 index funds, the Vanguard S&P 500 Index Fund ETF, ticker symbol VOO. This index fund charges an annualized fee of just 0.03 percent. Yeah, that's right — the fee is just three hundredths of one percent. Meaning for every one thousand dollars of this index fund you own, you pay just 30 cents a year in fees. So essentially nothing.

Contrast that to an actively managed mutual fund in which a portfolio manager and a team of analysts are working to try and pick winning stocks on your behalf. These people don't work for free, and there are a ton of expenses in running a fund. Those fees get passed down to you as an investor. It's not crazy for a fee for an actively managed mutual fund to be one percent. You may be asking yourself, “So what? It's only one percent.” And in any given year, you are probably right. But over an investing lifetime of decades, that one percent matters a ton.

Let me show you what I mean. Let's say we have two investors, Jack and Jill. Jack and Jill both have ten thousand dollars in their investment account and both have annual returns averaging eight percent. However, Jack has to pay one percent in fees every year, while Jill does not. This means Jack's true annual return is seven percent compared to Jill's eight percent.

After forty years, Jack, with his seven percent return, will have one hundred and forty-nine thousand seven hundred and forty-four dollars and fifty-eight cents. Not bad at all, considering one hundred and thirty-nine thousand seven hundred and forty-four dollars and fifty-eight cents of that is from investment returns, as Jack never put another dollar into his original ten thousand dollar investment account.

Now moving on to Jill. How much more money do you think Jill would have at the end of the same time period with just a one percent higher average annual return? Maybe you're thinking ten thousand, twenty thousand, or even thirty thousand dollars more. Let’s see. Jill would have two hundred and seventeen thousand two hundred and forty-five dollars and twenty-one cents, nearly seventy thousand more dollars than Jack, all because Jill didn't have to pay that one percent fee.

Now I bet you can see why index funds have become increasingly popular over the years. So now that we see just how powerful it is to avoid fees when investing, what exactly is Peter Lynch saying? That people that invest entirely in index funds are "missing the boat"?

I must admit up front, Peter Lynch may be a little biased because, after all, he was a portfolio manager at an actively managed fund. However, with that being said, he does have a pretty strong point. If you are able to fund an actively managed fund that outperforms the market, or if you are able to do it yourself, you can end up with a lot more money in your investment account. Remember how in the earlier example, Jill had 217,245 dollars and 21 cents in her investment account after the 8% return her index fund provided her after 40 years?

Let’s say in this example, we have another investor named Warren. Let’s say Warren is able to select actively managed funds that return 11% before fees. After the 1% annual fee is paid, Warren is left with a 10% annual return. That same 10,000 would turn into a staggering 452,592 dollars and 56 cents. That is a staggering 235,000 more than Jill, our index fund investor. In this example, that 10,000 original investment over 40 years at a 10% rate of return turned into 452,592.56.

The most impressive part of this is that 442,000 of that 452,000 is just from investment returns. This couple of extra percentage points in annual returns may not seem like much, but over an investing lifetime, it can really add up and make a huge difference in an investor's portfolio. This is what Peter Lynch is getting at when he says that investors who only invest in passive index funds are missing the boat.

In his words, that two to three percent in extra annual returns can add up to hundreds of thousands and even millions of extra money in your investment account if you are able to find a way to outperform the market. So this brings us to the million dollar question: how common is it to find an actively managed fund that outperforms the market? The answer isn't good news for us as investors.

According to a study done by the Dow Jones Indices on active versus passive management, the study found that 85 percent of active managers underperform the S&P 500. This means that the odds of finding an actively managed fund that outperforms the market is low. Now, this isn't good news for us as investors who are looking to outperform the market.

As someone who works as an investment analyst at a large investment fund, I think part of the reason why most fund managers underperform is because most fund managers are very short-term focused. They try to predict how stocks will move over the next day, week, month, or year, but it is pretty much impossible to predict short-term movements in the stock market. It is extremely difficult to outperform the S&P 500 when you are worried about how your portfolio performs every single day. If you want to learn more about this concept and why most professional investors underperform the market, you can check out the video I did on Seth Klarman and his book "Margin of Safety" here.

So how exactly is an investor supposed to balance the benefits of index funds with also wanting to maximize long-term returns and build wealth? I can tell you what I have done that has helped me build a 000 investment portfolio at 24 years old. Despite working at an actively managed investment fund, I still am a huge fan of index funds and think there is a place for them in every investor's portfolio.

I split my personal investment portfolio into two separate categories. The first being a tax-advantaged retirement account. In this account, I contribute 15% of my paycheck entirely into an S&P 500 index fund. Then, I have what is referred to as my actively managed investments. In this account, I run a concentrated portfolio of six to eight stocks. These stocks are in companies I understand have long-term durable competitive advantages and that I believe will be able to continue to grow for years to come.

These are all stocks that I plan to hold for years, as I let compound interest work its wonders. I also invest in real estate as an additional way to produce returns and diversify from the stock market. I buy rental properties in nice neighborhoods and plan to hold these properties for decades, benefiting from appreciation in the value of the house, rent paid from tenants, and debt paydown on the mortgage I used to purchase the properties.

This is how I personally incorporate index funds into my investment strategy while also not missing the boat, as Peter Lynch referred to in his interview. So there we have it. If you want to see what stocks I own in my personal investment portfolio, you can check it out here. As always, thank you so much for watching. Make sure to like this video because I really appreciate all the support, and make sure to subscribe to the Investor Center if you are already. Talk to you soon.