I am delighted to welcome a new occasional contributor to Monevator! Lars Kroijer was a successful hedge fund manager but he now advocates passive index investing as the best approach for most people. You can read more from Lars in his book, Investing Demystified .

T he vast majority of people have no edge over others in the stock market. Even professional fund managers who have demonstrated skill in picking stocks in the past struggle to beat the market once their high costs are taken into account.

This may sound like a counsel of despair, but its just a call to accept reality. You dont need to beat the market to invest successfully in shares and other assets. But you do need to try to get the average return from the different asset classes as cheaply and effectively as possible.

I have a term for those wise people who have accepted this – I call them Rational Investors.

The way of the Rational Investor

In my book Investing Demystified I explain how to be a Rational Investor:

1. As a Rational Investor you realise you cant outperform the markets, neither do you know someone who can.
2. The Rational Portfolio therefore consists of funds that track broad indices of equities as well as risky government and corporate bonds, and an allocation of minimal risk bonds 1 .
3. Think about your other assets in a portfolio context.
4. Think hard about your risk levels.
5. Be clever about tax.
6. Implement the portfolio as cheaply as possible.

Keeping costs low is vital to being a Rational Investor. Since you are not going to try to outperform the market, it makes no sense to pay a penny more than you have to in order to achieve as close to the markets return as you can.

Ironically, this will be your edge over those non-Rational Investors who are striving to do better.

By keeping costs low, you can end up richer than those who pay a high price to try to beat the market and fail.

Active management comes at a cost

There are too few people from the world of finance who are interested in emphasising the importance of low fees to investors.

Perhaps thats not surprising – they are after all the ones making money from those same fees.

Fees are always important in finance, but even more so for the Rational Investor. Since we don’t think we’ll be able to outperform the market, were not asking anyone to be particularly clever about investing. We just want someone to replicate the market .

As a result we should expect to pay very little for it.

Inertia is a powerful force. It either makes us leave our investments where they are or makes us buy the well-known active funds like so many others.

Many people are aware of the extra costs of these active funds, but often they don’t seem to act on it. Instead, they accept the status quo – please don’t let that be you.

It seems paradoxical that people spend countless hours comparing the price of computers or holidays, when the same time spent researching better and cheaper financial products would far outweigh the cost savings they make elsewhere.

The price of active management

The following table compares the cost of investing in a passive index-tracking product with investing in a typical active fund tracking the same index.