Ed Mamula.com

Time and again, investors are fed statistics on how few actively managed mutual funds outperform the S&P 500 index (or some other relevant benchmark).  A casual glance around the ‘Net this evening revealed to me that 80% of actively managed funds do not beat the S&P 500 index.  This bit of knowledge is usually followed by all of the benefits of owning index funds, such as low costs, “good” long term returns, a strategy that is easy to automate and guarantees average returns, etc.  The message is that it is so hard to beat the average that we should simply buy the index, and strive to be average.  This type of advice is never given in other areas.  “Jimmy, it’s tough to get straight A’s, so do as little work as possible and be happy with a C- average”.

Let me be the first to say just how easy it is to actively manage your own account and do WORSE than average.  It’s so quick and easy to set up an online trading account and start buying things left and right without any real strategy.  The trader who does this sure better hope the market really is random!  I suppose that this would be the typical life cycle of a risk-taking investor:  The young maverick boldly charges into the market.  He thinks that high risk equals high returns.  On cue, the market moves in his favor, and he becomes absolutely sure that trading is fun, easy, and highly profitable!  The maverick trader will inevitably get stuck in a losing position and have no pre-determined exit strategy.  At this point, his choices are to hold on and hope that the position will recover, or sell it out at a loss and “wise up” to the fact that he cannot beat the market.  His experiences with active management and personal financial loss with likely lead him to invest in index funds, where at least he can do no worse than the average.

But wait!  You saw the title of this article…and it’s true!  100% of S&P 500 index funds underperform the S&P 500 index.  Their costs may be low, but they are not zero.  In this way, index fund investors guarantee themselves a slightly below average return because they are afraid that any attempt to do better will land them a failing grade.  This does NOT mean that actively managed mutual funds are necessarily a better choice.  Actively managed funds do charge higher fees, and give their clients’ money a little bit of a deeper hole that it has to dig itself out of before it can even think about outperforming the S&P.  And indeed, just as there are many average investors, there must be many average money managers, all of which are willing to extract fees from investors and deliver a return just close enough to the average that their investors do not cash in their shares.

I believe that the average mutual fund manager’s primary motivation is to perform well enough to keep his job for another year.  To do this, he must deliver returns that are at least similar to his peers.  This tendency to fixate on the averages results in something I like to call “average cling”.  If the average money manager is simply going to invest in a basket of stocks that will perform close to average by design, what is he doing to deserve the management fee?  Average cling is like taking an exam and knowing what the curve will be ahead of time, then deciding to stick as close to it as possible so as not to stand out on the downside and get kicked out of the class.

Perhaps the best way to achieve above average results inside of a mutual fund is to invest with a manager that completely disregards the averages and strives for absolute return.  Such managers are rare, but certainly not unheard of.

Granted, the strategies above are aimed at passive investors; that is, those of us who do not want to spend our time picking stocks or other assets to include in a portfolio.  There are certainly higher return avenues available to investors who are willing to do their own work, but understand that consistently outperforming the market requires a love of trading and investing.  Just focusing on returns will not be sufficient motivation to put in the necessary work.  The necessary work is considerable, and it might just outlast your attention span.  

Index funds are STILL a good choice for the average, risk-averse, passive investor. It’s okay to be average. Just don’t let the establishment fool you into thinking that it’s impossible to break the curve.

(This article is part of the 87th edition of the Carnival of
Personal Finance…check it out!)

The Motley Fool will always occupy a special place in my heart.  When I was a teenager, I managed to save a few thousand dollars over the course of a couple of years.  This was the first time that I had any trading capital that I could control without parental supervision. (My first trade having been a wild ride in Pepsico through the 1987 market crash…)

Other than a few odd conversations with relatives who would claim to be making money holding various stocks, I had no source of financial education.  I’m not sure how I found the Fool, but I’m immensely glad that I did.   

The Fool is a great place for absoulte beginners to learn the basics of investing.  They publish an online guide called Our 13 Steps to Investing.

If you know nothing about trading and investing, please go there and read the first 9 steps.  Yeah, that’s right, the first 9.  The last 4 steps are marketing fluff designed to get you to subscribe to newsletters. 

It’s easy for an experienced investor to dismiss the Motley Fool, because the information presented there is rather basic and light, but for newbies, it’s a gentle and fun introduction to self-directed investing.   Maybe someday you’ll be a snobby graduate of the Motley Fool like me.

 On another, related note, I worked at the Motley Fool as a database programming intern for 2 years while I was in college.  I managed to land the internship mostly because of my enthusiasm about the company.  I really didn’t have the necessary skills at the time of the interview, but I had the drive to contribute to the company, and a man by the name of Kevin Book gave me a chance.  For those of you who watch CBNC, you might see Kevin from time to time.  He’s moved on to Friedman Billings Ramsey, and now he gives talking head analysis to CNBC.  Go Kevin!