Perhaps you smoke cigarettes. If so, you’re aware of the risks. But what if smokers also grew nostril hair (five inches a year) and it was impossible to cut? After four or five years, it would be down to their waists.

Fortunately for smokers, this doesn’t happen. The risks of smoking are all well known. But the same can’t be said for investing in actively managed mutual funds. They carry two well-known risks. The third, and arguably most harmful, isn’t well known.

First, there’s the obvious. Index funds beat most actively managed funds because index funds charge lower fees. According to Morningstar, in the ten years ending December 31, 2017, the typical U.S. Large Blend index averaged a compound annual return of 8.1 percent. The typical actively managed fund in the same category averaged just 6.6 percent.

Index Funds Win 10 Years Ending December 31, 2017
Compound Annual Returns

Category Actively Managed Funds Index Funds
U.S. Large Blend 6.6% 8.1%
U.S. Large Value 6.9% 7.5%
U.S. Large Growth 8.4% 9.7%
U.S. Mid Cap 7.6% 9.2%
U.S. Mid Cap Value 7.8% 9.1%
U.S. Mid Growth 7.7% 8.5%
U.S. Small Cap 8.1% 9.4%
U.S. Small Value 8.4% 9.1%
U.S. Small Growth 8.6% 9.5%

Investors in actively managed funds face a second, slightly less well-known risk. When an actively managed fund beats its index during one time period, that’s often the kiss of death. As the SPIVA Persistence Scorecard shows, active funds that do well during one time period rarely repeat the next.

But this leads to the third and, arguably, greatest risk of all. Actively managed funds drive people crazy. No, they won’t make you drool in your Starbucks Frappuccino. But they seduce investors into buying high and selling low. When you’re saving for retirement, that’s worse than drivel.

Here’s what happens. Many investors in actively managed funds believe they can beat the market. They usually pick funds based on past performance. If a fund has a strong market-beating record, they often buy that fund. But it doesn’t take long before such funds disappoint. Many investors regret their fund decisions, so they search for something else. A new hot active fund might catch their eye, so they jump on board. But after doing so, that fund begins to drag.

To be fair, plenty of index fund investors do this too. But because they aren’t typically trying to beat the market, they don’t hurt themselves as much.

Morningstar publishes the results in Mind The Gap: Active Versus Passive Edition 2018. For example, over the ten years ending December 31, 2017, the typical investor in actively managed U.S. Large Blend funds underperformed the funds they invested in by 3.30 percent per year. This is the result of buying high and selling low: of switching from funds that hadn’t performed well and jumping into funds that they hoped would soar.

If you recall from the table above, actively managed U.S. Large Blend funds averaged a compound annual return of 6.60 percent over the ten-year period ending December 31, 2017. But Morningstar says the typical investor in these funds underperformed them by 3.30 percent per year. That means they earned a compound annual return of just 3.30 percent per year.

In contrast, the typical passive (indexed) U.S. Large Blend fund averaged a compound annual return of 8.1 percent per year. Such investors weren’t perfect. They underperformed their funds by 0.72 percent per year. That means the typical investor in such index funds earned a compound annual return of 7.38 percent. There’s a big difference between 3.30 percent and 7.38 percent.

Below, I cross-referenced the results for the two relevant Morningstar studies. I wanted to compare how passive and active investors fared–after their behavioral blunders.

After averaging nine U.S. fund categories, the typical index fund investor earned a compound annual return of 7.78 percent. The typical investor in actively managed funds earned just 4.77 percent. In other words, the index fund investor would have turned $10,000 into $21,153.48 over the ten-year period. Investors in actively managed funds would have turned the same $10,000 into just $15,935.64.

If the money were invested in a taxable account, the gap would be even bigger.
That’s why investors should avoid actively managed mutual funds. They might not look like waist-length nostril hair. But if you’re banking on retirement, the results are just as ugly.

Index Fund Investors Come Out Far Ahead
10 Years Ending December 31, 2017
Compound Annual Returns

Category Actively Managed Funds Investors’ Results In Actively Managed Funds Index Funds Investors’ Results In Index Funds
U.S. Large Blend 6.6% 3.3% 8.1% 7.38%
U.S. Large Value 6.9% 3.7% 7.5% 5.98%
U.S. Large Growth 8.4% 5.1% 9.7% 8.08%
U.S. Mid Cap 7.6% 3.79% 9.2% 8.26%
U.S. Mid Cap Value 7.8% 4.51% 9.1% 7.30%
U.S. Mid Growth 7.7% 3.73% 8.5% 8.05%
U.S. Small Cap 8.1% 5.79% 9.4% 8.92%
U.S. Small Value 8.4% 7.07% 9.1% 7.07%
U.S. Small Growth 8.6% 5.94% 9.5% 9.05%
Investors’ Average* 4.77% 7.78%
End Value Of $10,000 Invested $15,935.64 $21,153.48

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas