Is it a lie that you can easily make money passively in the stock market?

Question

People on this site often recommend that investing in an index fund is a good, passive way to make money long-term.

But this is clearly not true.

Even if we ignore the risk associated with investing money in stocks and only consider some sort of best-case scenario by pretending you always get a 7 % return annually, you then have to subtract

1. Commission fees to the broker.
2. Inflation.
3. Pay the index fund.
4. Capital tax.
5. And finally, since you get money in the future, you have to remember to use the prevailing interest rates to calculate the present value of your return.

So, let's say we invest $100,000 and get a 7 % return, i.e. $7,000 a year later. Say you pay 25 % in taxes. You then only get $4,550. So you have $104,550 now. Say you pay 0.4 % to the index fund. That's about $400, so say you now have $104,150 dollars. Let's calculate the present value before we subtract commission fees (which are of course paid in the present). If inflation is 3 % and the interest rate is 1 %, then we need to discount by 1.04, which gives us $100,144. Subtract $144 for the commission fees, and you end up with the exact same amount you started with! All you've done is beat inflation, basically.

And remember, this is a best case scenario. In real life, you will have to face risk as well.

Is this analysis correct?

Answer 1

It seems your mind is already made up, given by this statement:

But this is clearly not true.

Your analysis ignores several details.

Commission fees to the broker.

For many brokerages the commissions are zero. You only pay the management fee of the fund, which is typically less than 1% per year.

Capital tax

Taxes on gains can be avoided by either using a tax favored account or by not redeeming your gains each year. Using this method allows the tax that one should pay to compound. Essentially you are taking an interest free loan from the government to invest allowing the "miracle" of compounding interest work for you with even more money. Sure taxes will eventually be due (Exception: Roth), but you don't have the ability to delay taxes on wages earned.

Inflation & Pay the index fund.

As GOATNine pointed out, the 7% includes inflation. The return of the FIDELITY 500 INDEX over the last 10 years is 9.46%, the fee is a paltry .035%, and the inflation about 2.4% per year. You are looking at a 7.025% return.

Most people do not experience inflation in line with the changes in the CPI.

The tone of your question suggests that you are seeking savings account regular returns but with equity rates. The market just does not work like that. One works, invests regularly, and after a period ends up with a huge pile of money that they did not do much to earn. It is not a get rich quick scheme nor can one pin down a date certain for financial independence.

The market gives, takes away, and then gives again. Studying the chart of the period of 2015 to the first quarter of 2016 is useful. During that time the S&P500 lost money. However, disciplined investors kept investing. It is a good thing too, they were amply rewarded on great run until Jan of 2018.

Answer 2

No, not correct.

First, beating inflation would already be an accomplishment - or do you know another way to do it?

Second, typical long term average is about 10%, not 7%.

Third, if you go with ETF funds instead of buying and selling shares directly, your fees are below 0.1% (otherwise, change the company), and there are no commissions to pay.

Fourth, taxes are applied to net gains, not to the initial differences. In your example, you paid the fees and commissions from taxed money, that is incorrect.

With this, your 100000 become 110000 in one year, minus 0.1% fee = 109900. if you take the 9900 out after a full year, you pay only 15% taxes, so you have 8415$ left.

That‘s a lot more than inflation; and it gets much better if you don‘t take it out, because you only pay taxes when you take it out, and if you leave it in, the ‘taxes‘ produce further income in future years before you pay them.

Answer 3

I have a theory: there is no way to make money using any means at all!

Let's say I work and earn 4000 EUR per month. However, when I work, I have to subtract the value of my time. For one month, the value of my time is 4000 EUR. 4000 EUR - 4000 EUR = 0 EUR, thus no gain.

Let's say I want to invest in bonds. They yield 3% per year. However, I have to consider that the returns are in the future and not in the present. Thus, I have to discount using my discount rate, which is, you guessed it, 3% per year. Thus, 0% per year return.

Let's now say I want to invest in stocks. They yield 8% per year. However, I have to consider that the returns are in the future and not in the present. Thus, I have to discount using my discount rate, which is, you guessed it, 8% per year. Thus, 0% per year return.

What is wrong with my analysis? Once you understand it, you start to finally understand what is wrong in your analysis.

Answer 4

Since no one's actually presented corrected calculations, here is how applying your own cherry-picked numbers properly works out. Spoiler: investing still comes out ahead.

Invest $100,000.
Gain 7%, subtract 0.4% expense ratio = $106,600
Subtract 25% of gain for taxes = $104,950
Subtract $144 (!?) in fees = $104,806
Note that depending on your tax situation that fee may be tax-deductible.
Present value at 3% inflation = $101,753

You still end up $1,753 ahead. And that's average case, not best-case as you asserted.

Now, say you put that $100k into a savings account making 1%.
At the end of the year, you'll have $101,000. Note that that's still behind the investment even before applying similar adjustments.
Subtract 25% for taxes = $100,750
Present value at 3% inflation = $97,815.
Note that leaving your money in a savings account making less than inflation, you actively lose present-value dollars.

That puts investing in an index fund at 4% ahead of a savings account.

Now, let's try this with some more realistic numbers.

Invest $100,000 in VOO.
Gain 7%, -0.04% ER = $106,960
Don't sell since we're investing long-term.
IF we sell it's long-term cap gains, 0-23.5% depending on income.
However, a nontrivial portion of the gain is from dividends, so let's say 3 percentage points of the return (so $3,000) is from non-qualified dividends¹:
Tax at 25% on $3k -> -$750 = $106,210
No fees because I invest in Vanguard funds through Vanguard.
7% returns are already inflation-adjusted.
So, present value is $103,116, over 3.1% gain;
Compared to a 1% savings account as calculated above this is a gain of over 5.4%.

Conclusion

Even with unreasonably high fees and pretending 7% return isn't already inflation-adjusted, you come out ahead of inflation and significantly ahead of leaving cash in a savings account. When using more reasonable numbers, an index fund comes out significantly ahead of inflation and even more so ahead of a "high-interest" savings account.

^{1. Picked to be conservative; if anyone has hard real numbers for this, let me know in a comment}

Answer 5

Say you pay 25 % in taxes.

In the United States, the long term capital gains rate is at most 23.8%. That's the maximum 20% capital gains tax plus a 3.8% Medicare tax. However, most people pay either 10% or 15% on capital gains and no Medicare tax. So this 25% rate does not reflect the experience of the typical person in the US.

People can also avoid taxes entirely with tax-privileged accounts (as previously mentioned). Most people are eligible for those and pay either 0% (Roth) or have their entire tax burden delayed until retirement. I won't repeat the math here, but if the tax rate is the same now as in retirement, the delayed tax burden is worth exactly as much as a 0% tax rate on gains. This is mostly because it avoids the tax on inflationary gains.

I don't know the specific rules in other countries, but I would expect most to have retirement accounts that are tax-privileged in some way. And of course capital gains often get better tax rates even if not in a tax-privileged account.

If inflation is 3 % and the interest rate is 1 %, then we need to discount by 1.04, which gives us $100,144.

The math is wrong. Those are not additive but multiplicative. So 1.0403. But the bank account's interest rate after inflation is no longer 1%. After inflation, the rate is about -2%. It's not particularly useful to put a negative number in that, so the normal thing would be to drop it.

As others have noted, the 7% already discounts for inflation. So we don't need to subtract inflation again.

$7000 minus $1000 (1% maintenance fee) still gives a $6000 gain. That's considerably better than the $2000 loss that a bank account would give (after 3% inflation on a nominally 1% gain). And of course bank accounts still have to pay taxes on the interest unless they are tax privileged.

Answer 6

Most of the costs listed in the question (whether correctly accounted for or not) are irrelevant to the difference between "passive" and "active" investing.

If your broker fees or taxes as an "active" investor were somehow lower than those incurred using an index fund, you could adopt the extremely minimal investment strategy of matching the index with your portfolio by hand and pocket the difference. Or I could set up a competing fund to save you the effort and split the savings with you, effectively undercutting the original index fund.

The only question that separates any of these approaches to investing, is who decides what to trade, what is that decision making worth and how much that decision making costs.

• When you invest in an index fund, the decision is based on the relatively unsophisticated process that defines your chosen index. The fund fees are essentially an administrative cost for maintaining that system.
• When you invest in a managed fund, you're paying a fund manager to make more sophisticated decisions that they expect to outperform the index. A combination of proprietary research and experience held by the manager and time spent applying this to the task of managing the fund might justify this expectation.
• When you actively manage your own investments, you are acting as a fund manager. It costs you nothing extra but your time. The payoff for this option depends on how well you expect your decisions to perform compared to those made by a professional fund manager or the baseline of an index fund - and how much you value the time spent on management and administration compared to the fees of the fund you're comparing with.

It is not necessarily true that you can "easily" make money passively in the stock market, but nor can you easily outperform that strategy. You can only do so by converting private knowledge into trading advantage. Acquiring this costs time, money or both, which economically makes it relatively "hard".

Answer 7

So, let's say we invest $100,000 and get a 7 % return, i.e. $7,000 a year later. Say you pay 25 % in taxes. You then only get $4,550. So you have $104,550 now.

So you have a basic misunderstanding of investment taxation. And FYI, 7000 * 0.25 = 1750...

4. Capital tax.

It's a capital GAINS tax. You need to book a GAIN before you pay a tax and long term (greater than one year holding period) is taxed at a lower rate than income.

All of the rest of your math, including "then commission is everything else that you made regardless of how divorced from reality this assumption in," is predicated on this flawed taxation assumption. So back to the drawing board you go.

Also notwithstanding the fact that your single year example is incongruous with the long term premise you're attempting to debunk.

Answer 8

I'm going to address your math directly.

So, let's say we invest $100,000 and get a 7 % return, i.e. $7,000 a year later. Say you pay 25 % in taxes. You then only get $4,550. So you have $104,550 now. Say you pay 0.4 % to the index fund. That's about $400, so say you now have $104,150 dollars. Let's calculate the present value before we subtract commission fees (which are of course paid in the present). If inflation is 3 % and the interest rate is 1 %, then we need to discount by 1.04, which gives us $100,144. Subtract $144 for the commission fees, and you end up with the exact same amount you started with! All you've done is beat inflation, basically.

First, most areas don't require you to pay taxes until you realize your capital gains.

So you have $7k in deferred income and $107k. No taxes have been paid. This is important, as deferred taxes are amazingly powerful.

You pay 0.4% to the index fund. So you actually have $106.6k, and have a future tax liability of $6.6k. Costs to invest are costs, not paid for out of taxable income.

Now, you paid a commission. The thing is, you only pay that once, and it too is deductible. You have $106.456k.

You have $6,456 in future tax liability and $106,456 after 1 year.

It is true you could have put the money in a bank. That money in the bank would earn $1k and be taxable immediatly at 40% (interest is usably higher taxed), leaving you with $100.6k after one year and no future tax liability.

Lets try 10 years.

You have a 6.6% return (after index fund fees), that compounds to 89.48%. You invested 100k and spend $144 on commission, so you started with $99,856 and end with $189,207.15 10 years from now and a $89,207.15 tax liability.

You liquidate and pay 25% taxes on your profits leaving you with $166,905.36.

Inflation of 3% per year means its value is actually 1/1.344 smaller than it is; it is worth $124,185.54 in "today's" dollars, or 2.4k per year.

Meanwhile, your option with the bank account. You earn 1% but pay 40% taxes each year, earning you 0.6% after tax. $100,000 * 1.006^10 is $106,164.62, an after-tax profit of $6164.92. Sadly, inflation also eats into this, leaving you with $78,991.53 equivalent in today's dollars.

So after 10 years you ended up with $24k free and clear in today's dollar value, plus your initial store of value back, and you have $45k more (in today's value) than if you put it in a savings account.

Instead you do it over 20 years you have $358,524.02. You liquidate and pay $64,631.01 in taxes, leaving you with $293,893.01. 20 years of 3% inflation means it is worth 1/1.806 as much as it seems, or $162,721.43 in today's value. You clear $62.7k in valid over 20 years, or $3.1k per year.

Note that this value is higher per year than the 10 year value. This is because we deferred taxes twice as far.

The numbers for the savings account will look abysmal. I'd be depressed to calculate them.

Finally, there is the route of a tax sheltered investment. Capital gains almost already cover this.

Suppose you have a 40% marginal rate and you can invest some pre-tax money in a shelter. When you take it out, you pay full taxes on the entire amount.

You have $100,000 in post-tax money, which is $166,666 in pre-tax money.

It grows by 6.6% per year for 20 years to $598,401.71.

You liquidate paying 40% tax and have $359,041.03.

After inflation this is $198,792.31, or $4.9k per year, post-tax.

Answer 9

Not clear how OP defines "easily."

There are several online stock market services where you can put in money once (or set up an automatic periodic transfer), and just ignore it. I put in a hundred dollars 297 days ago in one of them and looked two minutes ago for the first time in months. I would call that "easy."

It's now $104.82, which is a return of about 5.9%/year.

My IRA (also based on stocks) has done the equivalent of 6.89%/year while I haven't done anything to it in 322 days. I would also call that easy.

Inflation (USA) during that time has been less than 2.5%, so clearly making money this way is possible.

(One might say, "Yeah, but you're not getting rich." Well, having had beds and meals in two dozen countries since retirement, I feel like I'm already rich. Or to look at it another way, my Social Security alone is more than a dozen times the income of half the people in the world.)

Answer 10

Many countries offer systems where individual savers don't have to pay tax on savings up to some point; in the UK this is called an "ISA". This seems not to be available in the US.

Most countries also don't charge income tax on retirement savings until they're taken out in retirement. In the UK this is standard for pensions, in the US this is the "401k" system.

Where taxes are charged on investment income, there is usually some scheme which benefits holding the shares for a longer period, e.g. https://www.investopedia.com/articles/personal-finance/101515/comparing-longterm-vs-shortterm-capital-gain-tax-rates.asp

Answer 11

Not correct. You need to be careful with any recurring charges on any investment, especially for long-term and passive ones. Any maintenance charges will reduce your total capital by a bit, irrespective of whether you made a profit or loss in that period. This calculation cannot be generalized and it actually needs better upfront planning.

Answer 12

Is it a lie that you can easily make money passively in the stock market?

It is a lie to say you can easily make money passively. The definition by people of easy, is here is the money, this is the cheapest vehical product one can use, invest the money, and it grows.

1. You need to choose the right financial way of investing
2. You need to time the investment at a low point so it benefits from a rise
3. You need to know what you are investing in
4. You need to know what is a bad situation and what is good situation
5. You need to know when to take profits and accept losses

In the long term 10+ years the scale of return can be good. Invest at the top in 2000 and you would have broken even in 2017.

The more activity you put in to moving money the more it costs. Some assets are easier to get into and out of quickly.

Some products charge 3% to get involved and other 0.25%. Some have a low growth rate, bonds, but equally a low downside, while equities can become worthless in months.

And the above is just a simple description of the problems involved. To get a scale of the problem, a lot of professional fund managers under perform their market sector consistently, even with years of experience. Others have had consistent returns, because in their time of investing, the indicators they use correspond to the response of the market, but if this link changes, it all falls apart, which is what some managers found switching markets, and using similar strategies but in new areas like India and China.

The answer is always know your sector and market, and stay in what you know.

Answer 13

It's not correct. It is a lie, generally, that you can make money passively in anything. Land is about the only item you can justify for such a claim as it doesn't increase, yet the population does. Yet, that will eventually fail, too.

All else is misleading at best, not much more than charlatanism. The thing is, the market has to work by people being active -- using their human brains to build value and learn from mistakes. It hurts the market when people "try to make money" off of it.

All the popular press about investing is generally fraudulent (people who want more demand in their stocks), or misleading. It just another "easy money" scheme. Why should people who have no "vested" interest in the field, no expertise, get any return on their money at all?

Perhaps a sector is weak and needs money. The solution to that is to sell bonds.

Answer 14

The statement "you can make easy money passively in the stock market" is false. A few reasons in addition to what you list as concerns in your post:

1. Not all indexes always go up over a period of time My father was a Nikkei investor for several decades when it went down and he thought if he kept buying it, it would reverse. It didn't. He barely ended positive. The Nikkei index is the standard index for Japanese.
2. Money invested in the stock market comes from somewhere. There's no such income as passive income, as work somewhere is done - before, after, or some work during. Even if someone argues the dividends or gains are passively earned, this misses the fact that initial work had to be done on it, meaning this is really a return on some form of work.
3. Patience and focus take work. To be honest, I feel overwhelmed about sticking to a financial plan and I get stressed out all the time. I'm being honest and maybe it really is "easy" for everyone else, but I don't feel this way.

Also, I have friends who invest their money in their business over stocks and they do better! Investing in stocks may limit options, which is a cost too (though I feel your analysis kind of includes this).