Banks Are Not Your Friends. Meet Some Index Funds.

“Banks Are Not Your Friends. Meet Some Index Funds.” is a post by freelance writer and TimelessFinance contributor Adina J.

Banks are not your friends.

Yes, that’s a self-evident truism, but let me say it again:

Banks – and that includes the nice guy or gal at your local branch with whom you’re on a first name basis – are not your friends.

Their only goal is to make money, and they love it when you make it easy for them by offering up either your greed or your ignorance for exploitation. If the PF world is divided into “good guys” (the savers) and “bad guys” (the people who use HELOCs to pay for their Caribbean cruises), no such division exists for banks, who are happy not to discriminate when it comes to making a profit – anyone is fair game. It’s all very well and good – capitalism at its finest – until you realize that you’ve been had too.

I have always been a saver; delayed gratification is pretty much part of my DNA. My husband is a saver too, but mostly by consequence of the fact that he’s all into “stuff”. Together, we’ve got the art of saving down pretty good. What neither of us has mastered, however, is the science of making our money work for us. My husband is simply not interested in the nitty-gritty of financial matters, and my knee-jerk reaction to any investment jargon is to immediately lapse into glazed-eye/blank-mind mode. I do know that interest is a bad thing when it works against you, and a very good thing when it works for you. Without it, in fact, there will be no such thing as “Freedom-55” (or even 75) for us, because of that insidious little wealth-gobbler called inflation. All things considered, it’s too bad that getting a decent rate of interest on our money has become the ever-elusive Holy Grail of our financial life.

So, what are your average Mr. & Mrs. J. Doe to do when they’ve got money to invest, and no idea how to do it? They go to the bank, of course.

Historically, the bank is where money-wise folks stowed away their doubloons. When the other option is your mattress, the bank – with its reassuringly solid vaults (they still have those, right?) and its guaranteed interest rates – is a safe bet. Of course, the days of 5%+ interest rates are now a distant memory and a faint hope. A high-interest rate savings account will now get you, if you’re lucky, a measly 1 or 2% in interest. In the long run, with the actual cost of living galloping ever higher, you’re barely breaking even – or worse. But your average Mr. & Mrs. Doe are not total dummies; they decide to keep only their short-term savings (emergency fund and such) liquid in a high interest savings account, and look elsewhere for a more fertile soil in which to plough their retirement nest egg. Enter the mutual fund.

Let’s be frank for the moment. The average Canadian doesn’t save, if the latest polls are accurate. Negative saving percentages have been floated around in recent years. People who are actually actively saving for their retirement are a minority; of those, people who know and actually understand the abstract concepts behind the sexy language of ETFs, REITs and so on, are a further, and even smaller, minority. Wading through the PerFi blogosphere, you might be led to believe that minority is far more represented in the general population than is actually the case. It’s not. And that’s an important thing to keep in mind in understanding how easy it is for banks to make a profit.

So, back to the mutual fund. To the average Doe, who is motivated enough to read the mainstream financial press, mutual funds have a great rep. Every financial adviser out there is telling you that, to make your money work for you, you have to stick it into a mutual fund – carefully managed by financial Gandalfs infinitely wiser than you – and then sit back and watch it grow. It sounds so simple and so reassuring, no? All I have to do is go to the bank, answer a questionnaire about my risk tolerance, and voila! I’m good to go – only 30 more years of toil and trouble before I can move to Florida and take up lawn bowling. I don’t have to learn about stocks, or read about the TSX, or defaulting Greeks, or commodities in China, or butterflies in the Amazon – whew! I can just go about my day, comfortable in the knowledge that my money is being managed.

Of course, there is risk. They tell you that upfront. Even in a non-volatile economy there is risk, and in the current climate, well … Risk, risk, risk. But before you get a chance to reconsider your stance on GICs, they pull out the big gun. If you’ve ever been in an investment adviser’s office even once in your life, you’ve probably seen it – the chart. The message of the chart is simple (and I’m paraphrasing here): based on historical trends, over the lifetime of your investment, you will end up getting a totally awesome return on your investment. Well, that’s a relief, right? So, you’ll lose a grand here and there, but in the end, you’ll still be able to upgrade that lawn-bowling membership and afford the premium dentures. Win!

Lame attempts at humour aside, this more or less describes the process I have witnessed at 3 different major banks when it comes to dealing with RRSPs. [If you’ve had a different experience, I’m jealous. And I insist you tell me where!] Despite minor differences in pitch and delivery, the process is essentially the same. This gives the average Doe additional comfort – this is all there is out there, so evidently one is not missing out on anything. Right? More on that in a minute – but [SPOILER] it involves index funds.

One thing that consistently never came up in any of the discussions I’ve had with about half a dozen different bank employees over the course of the past 5 years is the sticky issue of MERs (and loads and trailers) – a.k.a. the fees that your bank charges you for “managing” your mutual funds. These can be as high as 2-3%, which only sounds like chump change until you realize that, at best, your total gross return might be in the 4-5% range in a recession economy. Sure, that might only work out to peanuts a year – but the bank is taking half your peanuts. For the privilege of playing with your money. Think about that for a moment.

Now, in the interests of fairness, I have to add the proviso that every investment advisor always brings up. The returns quoted for each mutual fund (when they’re being sold … ahem, explained to you) supposedly takes into account the applicable MER. In other words, you are being quoted the net interest rate. But here’s the rub: that interest rate is hypothetical, and it’s never guaranteed. It’s based on historical data about how markets have performed in the past. [Note from Joe: these shysters also cherry pick their most successful mutual funds to brag about.] Using past data for predicting future events is not the recipe for success so-called experts would have you believe; I highly recommend reading The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb which explains this process in an infinitely more erudite and entertaining way than I can.

The point of my philosophical digression is merely this: no matter what banks might like you to believe, they are only marginally better at predicting the future than the palm reader down the street. Are their financial analysts’ “gut instincts” about the market worth 2 or 3% of your investment returns? Perhaps so, if that was the only way you could get a return without having to do all the heavy lifting yourself.

But that isn’t the case — though the bank is in no rush to tell you otherwise. And here, finally, we come to the nub of my long-winded rant. The bank themselves actually offer alternatives to the old mutual fund. There is a thing called an index fund, which is a dissimilar beast, stripped of those prescient Gandalfs and their pricey MERs. For a non-scientific, but readable, explanation of index funds, check out Wikipedia. And if you want data on how index funds tend to stack up to regular mutual funds, return-wise, you can start at Boomer & Echo. The best part for your average Doe is that index funds are just as easy to get into as mutual funds – in fact, your bank most likely has a bunch of index funds for you to choose from. They probably just won’t tell you about them, unless you ask first. On the benevolently paternalist view of themselves, which they endlessly promote to the public, banks would have you believe they do this because – gosh darn it! – they just want you to make the most money you can, by grace of their infinite wisdom. The reality is that mutual funds keep their expensive analysts employed, and give the banks a profit. Index funds make them a profit too, just not nearly as much. You get to keep the difference in your portfolio, rather than giving it to the bank fieends.

Do I feel responsible – and pretty silly – for not educating myself on this topic sooner, and letting the bank make extra profit from my ignorance? Sure! But I consider it the price of a timely reminder: the bank is not your friend. No matter how much money you throw its way, that won’t change. You won’t make it like you any better. Well, maybe a little bit more, if you’ve got a few spare millions. Just a little. Maybe.

The bank is not your friend. Index funds, on the other hand, definitely are.

TimelessFinance will feature more articles about low-cost investing in the future. Topics will include index ETFs (like index funds, but traded on stock exchanges) and the best institutions for frugal investors. Do you have any questions about index funds, ETFs, low-MER investing, etc.? Please ask them in the comments section or submit them by email. We’d like to do a Reader Mail post on this topic in the near future.