A sucker’s bet hurts many investors

Mutual funds may be the most efficient and easy way for individuals to participate in the stock market, yet the average fund investor has not made anything like the market’s returns since 1984. What’s going on here?

There are two problems, both related to average investor behavior: one is the urge to pay someone to beat the market; the other is the tendency to chase recent market trends.  As a result investors are placing a losing bet with odds that are so stacked against them that they might do better in a gambling casino.

Enlightened investors should probably just stick to passively-managed index funds where they have a virtually 100% chance of participating in the market’s returns, writes John Bogle, retired chairman of the Vanguard Group and the founder of the first retail stock index fund. “The job of the investor is to get the market return, and we have it in indexing… a virtual guarantee (unless we mess up the index management) of giving you the market return,” he wrote in a recent issue of the Journal of Indexes.

Bogle noted in another forum that professionals dominate the markets and that as a group they will earn the market’s returns minus their costs of investing. He estimates that cost at about 2.9% of the average mutual fund’s assets. It so happens that 2.9 percentage points is about the difference between the stock market’s returns from 1984 through 2002 and the performance of the average stock fund during that same period. 

An investor who tries to beat the market will have a difficult time, he wrote. “Because of costs, you probably have, the statistics suggest, about a 4% chance of beating the market over 50 years,” he wrote. That means an active investor has a one in 25 chance of beating the market; the other 24 chances involve making less than the market. “I can’t imagine making that kind of bet,” he wrote. Investors don’t just lose out by selecting active fund managers and hoping to beat the market. They are also probably overwhelmed by the marketing behind the thousands of mutual fund choices presented by the industry.

Over the years the average holding period of stock funds has declined sharply, and statistics show that investors pump large amounts of cash into funds after those funds have racked up large returns and garnered attention. Unfortunately, the hot money often enters funds after they have peaked and new investors get much smaller returns than they expected, or even losses. In an opinion piece for The Wall Street Journal, Bogle estimated that the average stock mutual fund investor earned just 2.7% per year from 1984 through 2002, which he dubbed a “shocking shortfall” from the market’s returns.

Yet investors don’t have to make all of these decisions and take all of these risks. The stock market is risky enough as it is, without having to take on the individual risks presented by actively managed mutual funds. Instead, an investor can put money into a pure index fund that captures the entire returns of a market, or can use a passively managed asset class fund that buys all of the securities within a broadly specified asset class. Those funds will guarantee the investor a return equal to the market or to the specific asset class, minus the costs of investing.  If the mutual fund company keeps the costs low, then the return should be just a little below that of the index or asset class. Lower taxation is an added benefit. Fewer securities are traded within passive funds, so fewer taxable events take place and the investor receives fewer taxable distributions.