Individual Investors Don't Outperform or Match Stock Market Averages Over Time (~10% Nominal Annualized Returns), Even Though It Is Relatively Easy To Do ... Why Do We Make It So Hard?

The vast majority of individual investors don't receive investment returns over time which equal general market returns. Although a diversified basket of stocks, aka the stock market, has earned ~10% annually in nominal terms over a long period of time, and a 7% inflation adjusted real rate of return, most individuals earn less than one half of that.

Buying high and selling low is one reason. Another is investing in assets other than stocks and getting a lesser rate of return on those assets, such as bonds.

But the one not even generally recognized is that one (average annualized market return) minus anything equals less than one. I'm referring to the fees and charges by brokers and investment advisers. If each of us has an expert who is 'average' in capability, and by definition that's what we're likely to have, anything we pay to that manager serves to reduce the average return of stocks to something less than one.

The Simple Math Favoring Index Funds captures the essence of this all-too-true mathematical story:

"At the beginning of every year, active managers, fresh off the wounds of the prior year, declare that this year will be a stock picker’s year.  Unlike the prior year, in which settling for the market rate of return produced results better than most active managers, the successful investors this year will be the ones that demonstrate the best stock-picking skill.

In fact, this is true.  It’s always true.  There is always a dispersion of returns among stocks and the most successful investors will pick the best-performing ones, while avoiding the losers.  In 2014 ... there was ample opportunity for astute investors to beat the market, even though a majority underperformed.

But the implication that, in the new year, indexing—or settling for the market rate of return—will have its investors eating active managers’ dust is wrong. In fact, it’s mathematically incorrect. The very simple reason is that for every good stock picker, there has to be a bad one.  Who else are the good stock pickers buying from and selling to? If one investor overweights a stock or an industry, then someone else has to under-weight it.  For every winner who picks correctly, there must be a loser.

This fact might lead one to conclude that the top half of stock pickers will outperform the market at the expense of the bottom half. Unfortunately, that is not correct. The reason is because of the high costs of active management. The combination of transaction costs and fees is easily 1% for the average mutual fund, which may sound paltry, but it’s 10% of the historical return of the stock market.  Even among the best stock pickers, the ones who marginally outperform before costs will underperform after costs. So a majority of active managers are doomed to underperform the market return. . . .

In all markets, it’s a simple fact that outperformance before costs is a zero-sum game and after costs is a negative-sum game. To be certain, this does not mean that active management, when executed well, with low costs, cannot outperform the market.  It merely reveals that it’s a very tough game and that only the top echelon will succeed.

 Another excellent active management joke is that active managers will be able to anticipate and react to market declines and will be able to shelter an investor’s assets during a bear market. . . . the performance record overwhelmingly shows that market timing does not work . . . .

Most professions are positive sum. . . . On the other hand, money management is zero sum before costs and negative sum after costs.  An active manager can only add relative value by taking advantage of another investor—he/she has to buy a cheap stock from someone. While some highly skilled managers will be able to add value at the expense of others, they’d better do it with low costs, and the majority of investors are doomed to fail."

Summing Up

So there you have it. Matching or beating the stock market is hard to do unless we keep it simple and easy.

And that's because simple math reveals that one minus anything will equal less than one. Having an average manager who charges for his 'services' will get the individual investor a sub-market return each and every time.

So find a better than average manager, and one who doesn't charge much for his services, have him invest your money (MOM) in the same stocks where he invests his own money (his MOM), and you'll be among the few who outperform the market over time.

If you can't find that manager, then invest in a low cost S&P 500 index fund. Over time these funds will outperform the vast majority of accounts over time. For that reason, low cost stock index funds probably make the most sense for most individuals.

But don't end up like the average individual investor with a whole lot less than one. That's no fun.

That's my take.

Thanks. Bob.