Do You Want to Be Just Average?

(MoneyWatch)  I recently gave a seminar to Tiger 21, a peer-to-peer learning network for high-net-worth individuals. Here's what I was asked at the end of the presentation: "You present a very compelling case for passive investing. And my own experience with hiring managers and advisors in an attempt to beat the market is consistent with that evidence. So, why is it that so many people, including me, keep trying when the results are so poor?" The following is my explanation.

Arthur Schopenhauer was a German philosopher known for his clarity of thought. He had this to say about great ideas: "All great ideas go through three stages. In the first stage they are ridiculed. In the second stage, they are strongly opposed. In the third stage they are considered to be self-evident."

As Schopenhauer noted about great ideas, the idea of indexing was initially ridiculed. Edward C. Johnson III is the chairman of Fidelity. Listen to what he said about indexing: "I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best."

The following is the typical Wall Street response to an investor who asks about indexing as a strategy: "If you index, you will get average rates of return. You don't want to be average, do you? Don't you think you can do better than that? We can help you achieve that objective." The response is an appeal to the all-too-human need to be better than average. They ridicule and oppose indexing because it's the loser's game for them.

The mistake Wall Street wants and needs you to make is to fail to understand that by simply earning market returns, you'll earn greater returns than the average investor. The reason is that the average actively managed fund underperforms its benchmark by about 1.5 percent per year on a pretax basis (and by far more on an after-tax basis). In other words, by earning market returns you will outperform the average investor, and that includes professional investors. That's simple mathematics, as described by Nobel Laureate William Sharpe in his paper The Arithmetic of Active Management: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." The bottom line is that the only sure way to be above average is not to play Wall Street's game of active investing.

There's another explanation for why investors continue to play a loser's game -- they need to protect their egos. If an individual invests in an actively managed fund and the fund beats its passive benchmark, the investor takes credit. However, if the manager underperforms, the manager gets the blame and is fired, and a replacement is hired. From the ego's perspective, it's an "I win/I don't lose" game. On the other hand, investors who choose passively managed funds have no one to blame but themselves. This becomes an "I win/I lose" game. The ego prefers not to play a game it might lose.

In a great irony, Fidelity is now one of the world's leading providers of index funds.

Our next post will provide another explanation for the irrational persistence of efforts to outperform.