Why Most Investors Can't Beat the Market

Here's a piece from the New York Times on why most investors can't beat the stock market. In a nutshell, here's the reason: expenses. Transaction fees, sales loads, expense fees for managing a fund, taxes, and on and on -- all these add up to big money that is subtracted from any gains made by investments. And once these are subtracted, most investors/investments have returns that are below that of a simple market average. The details:

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

What are the investment implications of his findings? One is that a typical investor can increase his annual return by just shifting to an index fund and eliminating the expenses involved in trying to beat the market. Professor French emphasizes that this typical investor is an average of everyone aiming to outperform the market — including the supposedly best and brightest who run hedge funds.

Professor French’s study can also be used to show just how different the investment arena is from a so-called zero-sum game. In such a game, of course, any one individual’s gains must be matched by equal losses by other players, and vice versa. Investing would be a zero-sum game if no costs were associated with trying to beat the market. But with the costs of that effort totaling around $100 billion a year, active investing is a significantly negative-sum game. The very act of playing reduces the size of the pie that is divided among the various players.

Even that, however, underestimates the difficulties of beating an index fund. Professor French notes that while the total cost of trying to beat the market has grown over the years, the percentage of individuals who bear this cost has declined — precisely because of the growing popularity of index funds.

The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.

As regular readers know, I regularly post on why I invest in index funds and this piece summarizes my key reasons. And even with all this evidence, I know I'll get commenters (or at least people thinking) "Yeah, that's true for most people, but I can beat the market." Yeah, right.

Believe me, I know the lure of trying to beat the market -- I tried it for the first several years of my investing life. But I ultimately learned (the hard way -- by losing lots of money) that I couldn't consistently beat the market (sure, I'd get lucky now and then, but it was nothing I could replicate). That's when I switched to primarily investing in index funds.

Even today I still have some remnants of those poor decisions. I have mutual funds with high capital gains associated with them that I'd prefer to have in index funds. But the capital gains are so high that I don't want to take the tax hit for selling them either. That's why I'm taking a unique approach to adjusting my portfolio. The downside: it's taking a lot of time, effort, and money to get things straightened out.

I don't want this to happen to you -- especially younger readers who don't have a lot yet tied up in actively managed funds. That's why I continually suggest you all look closely at index funds for the majority of your investments.

For more thoughts on this issue from me, see these posts:

• Costs Can Cripple Your Investment Returns

• Index Funds Continue to Be Great Investments

• Investing Advice from a Guy Who Manages $22.5 Billion

• Kiplinger's Loves Index Funds

Comments

[Zook]

I think it is un-sexy to buy index funds and that is why folks don't. Index funds are like shopping at Wal-Mart. Folks want to have 18-mutual funds with 1.25% ER and 10 individual stocks to have something to talk about. They want to have 3 $200/yr newsletters and 6 money magazine subscriptions. They might get a few calls from brokers and want to feel "special" so they buy the crap the broker is selling.

Certain folks simply don't want to get educated. They don't want to be wise. They don't want to be told that there portfolio can consist of THREE mutual funds or maybe just ONE Target fund.

We all know these types of people. You give them solid, damn good advice and they walk away and don't implement it.

I hope articles and quality blogs like this one can pull in the person on the cusp, who wants to learn and do things right. However, there will always be folks, high and low income folks, who don't want to be told anything. They would rather pay 5% loads and high expense ratios on the funds. They would rather die without a will and 4-kids. They would rather invest in a 1.98% CD inside a Roth IRA at 30-years old. And on and on and on...

[AdamCO]

I have most of my retirement in what trowe price calls the, 'retirement 2050' fund. it is supposed to auto adjust over time i guess.

i suppose it must be actively managed to adjust over time. is this a foolish thing to do? would the index fund make more sense?

[J in FL]

Zook,

really good points! so true...

[GBlogger]

I totally get this post and know in my brain that it is true.... and still haven't managed to entirely rid myself of the urge to buy individual stocks. Much of our saving and investing plan concentrates on low-cost index funds or ETFs, but some of it goes into individual stocks.

[Darin H]

I used to be an individual stocks only person. I had 25 or so at one point a couple of years ago and I still have about 10, but as I sell them I take the money and put it into some low cost ETF (VTI the Vanguard total market one is good and now the bulk of my portfolio). I'll probably always own a few individual stocks though.

[Rev]

I do both. Index for retirement/long term, individual with my extra cash for fun/speculation. I take the route of instead of buying something I use that spending cash and have fun in stocks with it. basically as a hobby, that is probably the best route unless you are a full time investor.

[Rob]

I agree with you Rev, there's absolutely nothing wrong with playing around with your extra money. I have a friend that made over 3,000% in just a few months on a stock that he used "play money" with. As long as your retirement is fully funded (and properly diversified in the low-cost choices your plan provider give you) and you're attacking any debt, why not have fun.

[zook]

Fun? You want fun or do you want to handle your financial affairs like an adult? I got goals to reach and doing the right thing is serious stuff. You want fun, go to dave & busters.

If your fun account is 5%, you don't have enough skin in the game to make any sort of dent anyways. If you have 10%, it's no longer fun money and you are messing with your returns and wasting your time.

Everyone has a friend that "made" 3000%, just like everyone wins at casinos. LOL

[Carl Richards]

Another reason that using index funds results in better investor returns is that it really puts the focus where it should be:

1-Meeting your savings goals
2-Avoiding the big behavioral mistakes

Over the last 20 years the average investor in mutual funds earned 3.7% while the average mutual fund earned 10.7%. This is a huge deal (6-7% per year!) that noone really talks about. The majority has to be attributed to poor investor behavior (switching from this fund to that, or from emerging markets to the US, actually acting on the financial pornography).

Using passive (index) funds removes that temptation and puts the focus on the things that matter which also happen to be the things we can control.

Using passive mutual funds can help close the gap.

[Rob]

@zook:

Ok so your opinion is that an adult should spend discretionary money on dinner out, drinks, dave and busters, etc etc while a "childish" person would take that same money and put it in some speculative stock. Again you have to realize we're talking strictly about money that would have been SPENT elsewhere, not saved or invested.

Also, if your fund account is 5%, that's probably too much first of all. Second of all, this ties directly into what we have already established, which is that this money should not be used as part of a financial plan. I'm wondering how it is that you can't understand that it's not about making a "dent." It's about having fun doing what you want.

If I choose to eat at home instead of going out one week and save that $20 for something I consider more fun than going out to eat, then it's all good.

Don't tell me you live like a miser day in and day out with a sour look on your face because you're too uptight with your money to have some fun.

[Zook]

Yeah, you got me.

lol..

"Fun money" belongs no where near grown-up brokerage and retirement accounts. You want to blow money on crappy stocks instead of doing things right? Go ahead. Don't even remotely come off as you are your "friend" can beat the market over any reasonable period of time pissing it away in a fun account.

You might as well go to a casino and bet your "fun money" on black and save yourself the time and energy.

Oh yeah, I know a friend of a friend who's friends with some guy who made 5,000,000% on a stock. Beat that! lol...

Carry on....

[Mike]

So - a stupid question. How do you diversify, if you only own low expense index funds?

I'm sold on the concept that you can't beat the market with managed funds. For the individual investor, something like an S&P index fund is clearly the best choice. However, with managed mutual funds, I can pick fund genres, like Growth, Growth and Income, Aggressive Growth, International, yadda yadda. What's the equivalent diversification with low-expense index funds?

[FMF]

Mike --

Check this out and see if it answers your questions:

http://www.freemoneyfinance.com/2007/03/how_to_invest_u.html

[Zook]

Over a 25-year period, if you take 100 active funds, maybe 1 or 2 will "beat" the market index it tracked. So you got a 2% chance of picking a fund manager that will be the market AFTER expenses. Maybe after 10-years, you got 30% chance of picking a winner. A bunch of those funds won't even be around at the end of the 25-years and who knows how many fund managers are still around after 25-years!

As far as how you diversify? Say you have a 100% equity portion at 22-years of age and hold 80% US and 20% International. You could simply hold Vanguard Total Stock Market Index, which holds roughly 1,300 companies and hold Vanguard International Index, which holds like 2,000 companies.

And there it is. You got a few thousand companies being tracked for .19% for the US portion and .27% for the International fund. You get into the ETF's and it gets cheaper.

Maybe when there is more money to be had, you may want to get into specific small cap and large cap funds and of course it depends on what you have in your taxable accounts as well.

[rwh]

I have money in the Vanguard Wellington fund. It's performance the last 1, 5 and 10 years is:

1 yr - 4.26
5 yr - 12.23
10 yr - 7.53

The expense ratio is 0.27%

The Vanguard Balanced Index fund performance over the same time period:

1 yr - 0.49
5 yr - 9.45
10 yr - 5.37

The expense ratio is 0.19%

Now these funds are not exactly the same, as Wellington's stated goal is a stock portfolio of 60-70% all in mid and large cap US stocks (my prospectus says the stock allocation can vary between 45-65). The bond portfolio is mostly in corporates with some exposure to US treasuries.

The balanced index fund's goal is 60% in the Vanguard Total Stock Market index (so you get some exposure to small caps) and 40% in the Vanguard Total Bond index.

My question is whether it makes sense to move from Wellington to Balanced Index. Do you think they are comparable funds? And if so, the track record suggests Wellington has better performance. Or do you think they are not comparable because of the small cap component in the index fund?

My goal in choosing Wellington many years ago was a 60/40 asset allocation. It looked to have better performance than the comparable index funds offered by Vanguard and with such a low expense ratio I thought it would be a cheap way to get some professional management and...............beat the market.

[FMF]

rwh --

I have both of those funds as well (left over from my active management days -- now have large capital gains) and I'm not sure what I'm going to do with them yet (I'm in the process of moving out of a few things each year). But for now, based on what you've said above, I think it's ok to keep them.

[rwh]

FMF:

I only have the Wellington fund. I guess my question is whether it makes sense to move it to the balanced index fund. Capital gains aren't an issue as it's in an IRA. What causes me to hesitate is the track record of better performance.

[Ryan S]

I've been holding the Vangaurd target 2050. Not bad returns, although it is taking a beating lately, in the long run, it should perform very well.

[FMF]

I can only answer for myself. If it were me, I'd move it to an index fund since my goal is to consolidate all my investments into them. That said, your mileage may vary.

Anyone else have an opinion?