Las Vegas, Reno, Atlantic City are built on the simple premise that humans want to believe they will end on the winning side of a bet – even when the bet is rigged against them. Gamblers know the house is always a net winner. Some will win and more than half will lose. They know that the Vegas strip was not built because casino’s have been lucky. They just hope that luck will be on their side.
The same can be said in the investment world. The investors who place their money with active managers are analogous to the swarms of gamblers hoping for the big pay off.
Investors place their money with active managers even though many know that over 10 year periods, active managers underperform indexes almost 90% of the time. Investors are willing to incur high fees and transaction costs in the attempt to beat the market. But year after year only 1/2 of active managers beat their index benchmark, the other 1/2 underperform. This is a mathematical fact. When you add in fees and transaction costs well over 1/2 of active managers/mutual funds underperform their respective market index.
Why do investors ignore this mathematical certainty and continue to pay high fees for active management?
It is the power of HOPE over PROBABILITY.
Like a gambler at a casino, many investors ignore the probabilities and hope to find a way to beat the market. They pay for stock and mutual fund picking advice, they pay high mutual fund fees, they pay for expensive newsletters, all in the hope that they can have an edge in outsmarting the market and be on the winning side. Unfortunately, to date, there is no system that exists that will outperform the market on a risk adjusted basis. If there was wouldn’t we all be following it?????
When it comes to your future does it make sense to put hope over probability?
Remember these 5 truths about capital markets:
1. Higher return means higher risk. Your friend who talks about his big returns is taking a bigger risk than you. That means that when times are bad he is likely losing more than you.
2. The index return of a market is the average of all investors returns in that market. That means about 1/2 outperform and the other 1/2 underperform that particular market.
3. Net of fees, more than 1/2 must underperform the respective index of the market.
4. Over time very few stock pickers or mutual funds consistently outperform the market – the one who outperforms in a given year is not the same who outperforms in the following year.
5. It is impossible to predict the winners ahead of time.
When investing in the stock or bond markets why not invest in index funds and be like the casino – knowing that math is on your side and that over time you have a high probability of outperforming the average active investor.
NOTE: This does not mean that you are guaranteed to have a positive return with index funds. It simply means that over time, net of fees, indexes outperform the majority of active managers with the same investment style.