In the market, survival is the top priority, and the most important factor in achieving this is not losing. This is due to the asymmetry of gains and losses—losses have a disproportionately negative impact compared to gains. Therefore, avoiding excessive losses that could make it impossible to continue investing is crucial. In this regard, one of the most effective ways to manage risk is through asset allocation.

Many asset allocation strategies are built on portfolio theory, also known as the Markowitz model, which explains how diversification can help investors manage risk. Portfolio theory shows that combining multiple risky assets can reduce a portfolio’s overall risk.

If you're interested, I’ve written more about this topic in the following two blog post. Feel free to check them out!

Portfolio Theory Explanation

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Asset Allocation and Index Funds

There are various ways to implement asset allocation, and one of the simplest yet most effective methods is utilizing index funds. Index funds are portfolios composed of diverse assets designed to reflect the overall performance of the U.S. stock market (or financial markets and specific sectors).

Nobel laureate Paul Samuelson once said, "John Bogle’s invention of the index fund is as important as the invention of the wheel and the alphabet." This statement underscores how revolutionary index funds are, as they allow the majority of individual investors—not just professionals—to fully benefit from them.

As John Bogle emphasized in his book, The Little Book of Common Sense Investing, index funds have significant advantages over actively managed funds in terms of cost and tax efficiency. Moreover, holding index funds for the long term prevents individuals from making inefficient investment timing decisions, ensuring that the profits generated by companies are fully returned to investors.

Exchange-traded funds (ETFs) that track indices such as the S&P 500, Nasdaq, and Dow Jones have different objectives, management approaches, and cost structures than traditional index funds. However, when held as long-term investments rather than for short-term trading, these ETFs can achieve the same investment goals as index funds. Therefore, the insigh ts discussed in this post regarding index funds also apply to index-tracking ETFs when held with a long-term perspective.

Purchase The Little Book of Common Sense Investing

CAPM and the Market Portfolio

Before diving deeper, let’s first explore two key concepts essential to understanding index funds: the Capital Asset Pricing Model (CAPM) and the market portfolio.

The Capital Asset Pricing Model (CAPM) is a financial theory that explains how the expected return of a risky asset is determined. Unlike portfolio theory, CAPM introduces the concept of a risk-free asset, which includes government bonds, fixed deposits, and certificates of deposit (CDs). These are considered safe investment instruments with minimal risk of capital loss.

When risk-free assets are available, the efficient frontier—traditionally represented as a curved line—transforms into a straight line, significantly altering the way investors construct optimal portfolios.

In the diagram above, the Efficient Frontier (EF) represents the opportunity set composed solely of risky assets. However, when a risk-free asset that provides a 10% annual return is introduced, the efficient investment opportunity set is no longer curved but instead forms a straight line. This line is known as the Capital Market Line (CML), which serves as a key reference for investors in determining how to allocate their funds between risk-free and risky assets.

The portfolio at the point where the CML touches the Efficient Frontier is called the Market Portfolio. The market portfolio is one of the most crucial concepts in CAPM, as it represents the optimal combination of risky assets that all investors can theoretically access.

In other words, the most efficient investment strategy, according to CAPM, is to invest in the market portfolio. In practice, the best way to implement this strategy is through index funds. Index funds transform the theoretical concept of the market portfolio into a tangible investment product by tracking the overall market. This naturally enables asset allocation and diversification.

Thanks to this characteristic, index funds effectively eliminate unsystematic risk—the risks associated with selecting individual stocks. For example, risks arising from poor performance of a specific company, downturns in a particular industry, or the failure of an individual fund manager’s strategy can be avoided.

As a result, the only risk investors must bear is systematic risk, which stems from overall market fluctuations. Systematic risk includes macroeconomic factors such as interest rate changes, economic recessions, inflation, geopolitical risks, and global economic shifts. While unsystematic risk can be mitigated through diversification, systematic risk cannot be completely eliminated. However, under the assumption that markets grow over the long term, index funds offer a stable and effective investment strategy.

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Compounding Costs and Index Funds

Index funds are highly cost-efficient investment products. To illustrate the impact of compounding costs, let's assume an annual return of 7% and compare two scenarios: one with no fees and another with a 2% management fee.

If you start with $10,000 and invest for 50 years, the final asset value will grow to approximately $275,300 with no fees. However, if a 2% annual fee is applied, the final asset value will be reduced to only about $102,300. When represented as a ratio over the years, the results are shown in the chart below.

In the first year, a 2% fee may seem insignificant, but its impact grows significantly over time:

• After 10 years, the total asset value is reduced by 17%.
• After 30 years, 44% of the value is lost.
• After 50 years, a staggering 62% of the potential wealth disappears.

This example once again highlights the powerful effect of compounding. Compounding has a magical ability to exponentially grow wealth over time. However, the same principle applies to investment fees—costs also compound, gradually eroding long-term returns.

Given this, reducing portfolio costs is a crucial factor for long-term investment success. Index funds have a cost advantage over actively managed funds and traditional equity mutual funds due to their lower expense ratios. As a result, for long-term investors, low-cost index funds can be one of the most efficient investment vehicles.

Costs of Active Funds vs. Passive Funds

Before diving into specific cost components, let’s first define active funds and passive funds.

An active fund is a fund in which a fund manager actively selects stocks and adjusts the portfolio based on market analysis and investment strategies. The goal of active funds is to outperform the market average, which requires analyzing individual stock values, macroeconomic trends, and industry movements. Common examples include hedge funds and equity mutual funds.

In contrast, passive funds are designed to track market indices (such as the S&P 500 or Nasdaq) and do not actively trade individual stocks. The most common forms of passive funds are Exchange-Traded Funds (ETFs) and index funds.

Compared to actively managed mutual funds, index funds offer significant cost advantages in terms of management fees, sales charges, and trading costs due to turnover (trading frequency).

Since active funds require fund managers to actively select stocks and rebalance portfolios, they incur higher management fees and sales commissions. Moreover, frequent trading can lead to hidden transaction costs, which can significantly erode investment returns over time.

On the other hand, index funds involve minimal unnecessary trading, resulting in lower management fees and transaction costs. This cost-saving advantage allows investors to maximize their long-term net returns.

A study by John Bogle analyzing the performance and costs of equity mutual funds from 1991 to 2016 found that the lowest-cost funds outperformed the highest-cost funds by 1.5 percentage points in risk-adjusted returns. Considering the earlier example of the impact of a 2% fee, even a 1.5% difference in costs can have a substantial effect on long-term investment performance.

Taxes on Active Funds vs. Passive Funds

Another key difference between active and passive funds is tax efficiency.

Since active funds have a high turnover rate, they are often subject to higher tax rates on short-term capital gains, making it difficult to defer taxation. As a result, investors in active funds may face a heavier tax burden.

In contrast, index funds follow a long-term holding strategy, allowing capital gains taxes to be deferred until the point at which gains are realized. This tax-deferral advantage helps investors retain more of their returns over time.

Moreover, index funds offer tax advantages when assets are passed on to heirs. The tax burden on inheritance can be minimized, and since index funds involve minimal stock switching, capital gains taxes are further reduced.

Ultimately, index funds outperform active funds in terms of cost savings and tax efficiency. When considering low management fees, reduced transaction costs, and tax benefits, index funds emerge as a highly attractive investment option for long-term investors.

At this point, some readers may be wondering: "Wouldn't it be better to invest in a fund with higher returns, even if it comes with higher costs and taxes?"

To address this question, let’s explore two key concepts: Regression to the Mean (RTM) and the issue of investors’ inefficient market timing decisions.

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Active Funds and Regression to the Mean

When selecting an active fund, what criteria do you use? Most investors look at past performance, assuming that funds with strong historical returns will continue to perform well in the future. However, according to research by John Bogle, this approach is often less rational than simply investing in an index fund for the long term.

This is because long-term returns tend to revert to the mean. In other words, active funds that significantly outperform the market over a certain period tend to see their performance regress to or below the market average over time. Additionally, active funds that consistently underperform the market eventually disappear.

A striking example of this phenomenon is the survival rate of stock mutual funds. Of the equity funds that existed in the 1970*, only two remain today (as of February 2025): the Fidelity Magellan Fund and the Fidelity Contrafund. If we compare the performance of the Magellan Fund to the S&P 500 Index from 1980 to the present, we can observe significant fluctuations in relative performance over different periods.

If an investor had invested in the Fidelity Magellan Fund from 1980 to the present (February 2025), they would have accumulated approximately 2.95 times more wealth compared to investing in the S&P 500 over the same period (excluding dividends and taxes for a simplified comparison). At first glance, this might suggest that selecting the right fund can lead to significantly higher wealth accumulation. However, a closer look at performance trends over different periods tells a different story.

During the time legendary investor Peter Lynch managed the Magellan Fund(until 1995), it significantly outperformed the S&P 500, allowing investors to accumulate 2.74 times more wealth than those who had invested in the index. However, from 1995 to 2020, the fund's performance stagnated, producing little to no additional gains compared to simply investing in the S&P 500. This outcome reflects the Regression to the Mean (RTM) phenomenon, where the Magellan Fund’s returns gradually converged toward the market average.

Although the fund's performance appears to have improved again in the mid-2010s, this is likely a temporary trend, and the fund remains susceptible to reverting to the mean at any time.

Additionally, active fund performance heavily depends on the fund manager’s skill and strategy, leading to greater variability and risk, particularly during periods of market volatility. For instance, after 1995 and during the 2008 financial crisis, the Magellan Fund experienced significantly larger losses than the S&P 500, as evident in the sharp declines in its performance graph.

Investors’ Inefficient Market Timing

Another critical issue is investors’ tendency to buy funds based on past performance**, which often means buying at market peaks. Many investors ignore equity funds when stock prices are low but pour money into them when the market is soaring, driven by optimism and greed at peak levels.

However, according to the Regression to the Mean (RTM) principle, funds purchased at market highs are more likely to underperform the average market return or even incur losses. Repeating this mistake over time can lead to significantly lower wealth accumulation compared to simply holding the S&P 500 for the long term.

In other words, choosing active funds in pursuit of higher returns does not necessarily lead to better investment outcomes.

The Importance of Long-Term Investing and Index Funds

In the short term, active funds may outperform the market, but over the long run, they tend to regress to the mean. Additionally, many investors engage in inefficient market timing, often buying into funds during market upswings and selling in panic during downturns, which reduces the likelihood of achieving their expected returns.

In contrast, index funds track the overall market and provide a stable long-term investment strategy. Therefore, for investors focused on long-term wealth accumulation, it is often more rational to hold low-cost, tax-efficient index funds rather than paying high fees for actively managed funds.

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Summary of Key Takeaways

• The most important principle in investing is to avoid losses that are too large to recover from.
• To achieve this, investors need a strategy that reduces both the frequency and magnitude of losses.
• One of the most effective ways to accomplish this is through asset allocation.
• According to portfolio theory and the CAPM model, investing in the market portfolio eliminates unsystematic risk associated with individual stocks, leaving investors only exposed to systematic market risk.
• Therefore, long-term investing in index funds, which closely resemble the market portfolio, is one of the most efficient investment strategies.
• Additionally, incorporating bond funds alongside equity index funds can further reduce portfolio volatility and enhance stability.

What Are Your Thoughts?

Through John Bogle’s index fund philosophy, we have seen how reducing costs and tracking the market average over the long term**can be a highly effective investment strategy. More importantly, asset allocation remains one of the most powerful tools for achieving stable long-term returns.

The core value of asset allocation lies in efficient risk management—allowing investors to maintain steady performance without being overly influenced by the volatility of any single asset class. Instead of concentrating investments in a single asset, diversifying across different asset types helps navigate market uncertainties more effectively.

However, there are many different approaches to investing. While asset allocation focuses on reducing volatility and ensuring long-term stability, some investors take a more active approach to maximizing returns by analyzing market trends.

One such strategy is Momentum Theory. Unlike a buy-and-hold approach that simply remains in the market over the long run, momentum investing seeks to maximize profits by buying assets that are rising and selling those that are declining.

In other words, the core principle of momentum investing is based on the trend-following nature of the market—assets that have recently risen in price are more likely to continue rising, while those that have recently declined are more likely to keep falling. This strategy takes advantage of market trends to generate returns.

In the next post, we will explore how momentum investing works and how it can be effectively applied in real-world investment strategies.

What do you think? Do you believe that stable investment strategies like asset allocation**are more important, or do you find trend-following strategies that capitalize on market movements more effective? Let’s think through it together.