Why Indexing Doesn’t Mean Settling For Average Returns

Why are you settling for average returns? That’s one of the biggest criticisms I received after selling my portfolio of dividend stocks and switching to a two-ETF passive indexing approach last year.

It’s true, I had thrown in the towel and given up on beating the market. But what many stock-pickers fail to understand is that index investing isn’t synonymous with mediocrity. Far from it! In fact, the evidence is clear that passive investors – the ones who invest in index mutual funds or ETFs – achieve better returns than the vast majority of investors simply by accepting what the market delivers, minus a small fee.

So in what universe does average not actually mean average? No wonder the concept is incredibly difficult to explain. Indeed, it’s tough to get the message across to stock-pickers and active investors that achieving market returns is far from average – it beats 90%+ of investors over the long term – not to mention that the 10% who might beat the market are either deep-pocketed professionals (i.e. Warren Buffett) or extremely lucky individuals. Either way, that formula is incredibly difficult for an individual investor to overcome.

Here’s my take: Imagine you’re a professional tennis player new to the ATP world tour. As a young player, you have virtually no chance to beat the likes of Serena Williams and the top players on the women’s side, or Novak Djokovic and the top players on the men’s side.

You’re given the option to sit out the year and collect an average of all the winnings paid out for tournaments and Grand Slam events, or to take your chances and play the best in the game. The top 200 money leaders on the men’s side earned a combined $32 million in prize money so far this season, with nearly half that total coming from the top 20 players. The top 100 money leaders on the women’s side have earned a combined $25 million, with half the earnings coming from the top 15 players.

The average earnings on the men’s draw would get you $160,988 and 57th place out of 200 players. That’s in the top 30% – not right in the middle of the pack as some might suspect (confusing average, or mean, with median). The average earnings on the women’s draw would get you $253,410, good enough for 24th place out of 100 players.

Of course, if your goal is to have fun and compete for glory and a chance to beat the best tennis players in the world, then by all means go out and play. But the statistical probabilities clearly show that the better move is to sit out and collect your winnings. There’s no chance of injury (the equivalent of making a major investing mistake), and you’re all but certain to beat the vast majority of players on tour.

I reached out to some leading experts on the topic of index investing to share examples and help drive this point home:

Why index investing doesn’t mean settling for average returns

In The MoneySense Guide to the Perfect Portfolio, author and Canadian Couch Potato blogger Dan Bortolotti explains that many people are put off when they first learn about index investing, especially the part about earning “average” returns:

“Do you imagine yourself in a room full of investors, about half of whom are doing better than you are? If so, you’ve missed the point. Index investors don’t strive to be average investors; they try to earn returns that equal the market averages. There’s a huge difference between the two ideas.”

Bortolotti, who is also an investment advisor at PWL Capital, says:

In my experience this a mental obstacle some people never overcome. I think the problem is with the word “average.” What we’re talking about here is market averages, but it’s too often interpreted as meaning “average compared to other investors.” So I try not to use the term anymore: we talk about investors getting “market returns.”

Preet Banerjee, who blogs at Where Does All My Money Go, says:

“One of the world’s greatest investors, Warren Buffett, is also one of the biggest advocates of index investing. He made a bet with a professional money management firm that a simple index fund would beat their expertly selected portfolio of five hedge funds over a 10 year period.

 

We’ve got two years left on the bet but Buffett’s index fund (which simply tracks the S&P500) is up 65.67% versus 21.87% for the hedge funds. Here’s a perfect example of how ‘settling’ for the market return is often pretty spectacular compared to the alternatives.”

Robin Powell, who blogs at The Evidence-Based Investor, says:

“There so much emphasis on beating the market that we tend to forget how generous market returns actually are. The vast majority of investors don’t need alpha (i.e. returns over and above market returns); and yet by seeking alpha they almost invariably end up worse off.

 

The active fund fund industry misleads investors by suggesting that indexing means ‘settling for average’. After expenses, active investors are almost invariably settling for considerably less than average.

 

The average passive investor must — that’s right, must — outperform the average active investor net of costs. In effect, indexing guarantees that you’ll be one of the winners. Why would a typical investor want to turn down that opportunity?”

Andrew Hallam, former stock-picker turned indexer and author of Millionaire Teacher, says:

“The typical 30 year old investor will have money in the market for 47 years or longer. Few mutual funds, if they last that long, will ever beat the market after fees for 47 years. Trying to beat an index over half a century (whether through your own stock picks or fund selection) is like gambling your retirement against very long odds indeed.”

Ben Carlson, who blogs at A Wealth of Common Sense and authored a book with the same title, says:

“I made a point in my book about this on how earning average index returns makes you an above average investor (and that’s before you bring in things like taxes and such). There was an example in the book, The Coffeehouse Investor, by Bill Schultheis that goes something like this:

 

He lists out 10 dollar values in bingo board style of different boxes from $1,000 to $10,000 (so $1,000, $2,000, $3,000, and so on). He asks which one you’d pick if given the option. Obviously you’d take $10,000. In the next example he moves the values around but covers all of them up except for the $8,000 box. In something of a “Deal or No Deal” style game you have the option to take the $8,000 straight up or take your chances to try for the $9,000 or $10,000, but also have the possibility of only getting $1,000-$7,000.

 

Obviously, anyone who understands probabilities would take the guaranteed $8,000 instead of pressing their luck to try to to a little better but have a much higher probability of doing worse.”

Another former stock-picker turned indexer, Michael James on Money, says:

“There are two effects that matter here. The first is costs. Active investors have higher costs. For stock-pickers, the main costs are commissions, bid-ask spreads, taxes, and “chasing”. Mutual fund investors can add MERs and internal fund trading costs. I find that stock pickers consistently don’t understand that they pay half the bid-ask spread on each trade. They also typically cannot accept that they are guilty of chasing hot stocks after they become expensive.

 

The other effect has to do with the distribution of returns. To see this, imagine a group of investors who start with $10,000 each. Over 25 years, say the index grows 10x. Let’s ignore costs for the moment and suppose that on average these investors get the market return. So, their average portfolio size after 25 years is $100,000. However, half of them trail the market average by 4% per year.

 

Many people think this means the other half must have outperformed by 4% each year. However, this isn’t true. If we do the math, we see that the other half only outperform by 2% per year. The reason for this is that the higher return investors are growing ever-larger pots of money. That means that more than half the money attracts the higher returns.

 

For one investor to outperform strongly, it takes several investors to perform poorly. In the end, you get a lot of investors who lose to the index and just a few who beat it. And the margin by which the good (or lucky) investors beat the average tends to be small. Then when we take off all the extra portfolio costs, many of these formerly outperforming investors are now trailing to the index. This leaves only a lucky few who outperform over the long term.

 

The end result is that over long periods of time, index investor returns place very highly in the range of active investor returns.”

Final thoughts

I used to think that stock-picking was easy – that all I needed was a tried-and-true formula to follow for the long-term and I’d be fine. But sticking to that formula was harder than I had imagined. I bent the rules and bought smaller-cap dividend stocks. I strayed from long-time dividend growers and bought some high-yield stocks. I lacked the patience to sit on the sidelines and wait for stocks to go on sale.

I also noticed behavioural biases which made me convince myself that I was a great stock-picker and not just a boat being lifted by the rising tide. I was overconfident, suffered from home country bias, and never truly experienced a bear market to test my mettle.

To use Ben Carlson’s example, I think the key to overcoming my biases and finally embracing a passive index investing approach was the realization that I was better off (from a time, effort, and money perspective) accepting the $8,000 box rather than playing for the small chance of getting a $10,000 box and (more likely) risking ending up with a $5,000 box.

I curbed my competitive streak and accepted the fact that indexing and achieving market returns doesn’t mean I’m settling for average returns.