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.

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24 Comments

  1. Grant on April 3, 2016 at 1:25 pm

    Rob, nice review of this confusing point. Active managers often play this confusion to their advantage – “you don’t want to get just average returns, do you?” – failing to mention, of course, that the average of the market, or market return, is much above what the average investor gets, due to the underperformance of the very funds they are trying to sell!

    • Echo on April 4, 2016 at 6:08 pm

      Hi Grant, yes I hear that argument a lot from advisors. It’s a shame that we can’t just get the industry to understand something when its salary depends on not understanding it.

  2. Curt on April 3, 2016 at 5:26 pm

    Great article. I will be saving it as probably the best explanation I have seen to date. I will be sharing it. Well done.

    • Echo on April 4, 2016 at 6:09 pm

      Hi Curt, thanks so much. I appreciate your comment (and the share).

  3. Garth on April 3, 2016 at 6:53 pm

    Well done Rob. As a committed indexer, I am always amazed at how dead simple it is. The hard part is staying the course through thick and thin and rebalancing when every fiber of your being is screaming that “this feels so wrong!”

    Simple, but not always easy.

    • Echo on April 4, 2016 at 6:10 pm

      Hi Garth, thanks for your feedback. It is a bit unnerving to take the George Costanza approach and do the exact opposite of what your instincts tell you 🙂

  4. Blake on April 4, 2016 at 6:57 am

    People ruin their own returns. By that I mean the biggest factor in returns in not necessarily which mutual fund or ETF but investor behaviour. You yourself just said in this article about picking stocks. Investor behaviour has the biggest impact on returns.

    • Echo on April 4, 2016 at 6:06 pm

      Hi Blake, it’s true that the real enemy when it comes to investing is the one looking back at you in the mirror. The one solid argument for dividend investing is if the steady stream of dividends gives you peace of mind and prevents you from selling in a panic during a downturn.

      My own personal experience from switching to indexing is that I now rarely look at my portfolio or care about what’s happening with any particular company or sector. But when I owned 24 dividend stocks I closely tracked their every movement and had to resist the urge to act on the overwhelming amount of analysis and information out there about each one.

  5. len on April 4, 2016 at 7:38 am

    I, for one would not trust my financial future to
    index investing. The people who advocate such
    a strategy won’t be around in 30- 40 years,
    so they are just like any other financial advisor
    “Trust me , everything will be OK” they will reap
    their rewards and be nowhere in sight when the day
    of reckoning comes.

    • Echo on April 4, 2016 at 5:54 pm

      Hi len, where does someone with such a pessimistic outlook of the world keep his or her long-term savings?

    • Grant on April 4, 2016 at 6:55 pm

      Len, the difference is that the advice on indexing is based on peer reviewed academic research, not just someone’s opinion.

  6. Tawcan on April 4, 2016 at 11:48 am

    Great write up Robb. I’m more of a DGI guy but lately have been adding more and more index funds. Plan to do a bit of hybrid.

  7. Peter A. on April 4, 2016 at 4:28 pm

    Great comment! I have been trying to go in that direction for months now, though I still don’t know how to start.

    Here’s my dilemma. My wife and I are retired, and I manage our portfolios by myself. I have 7 accounts (RSP, TFSA, LIF, Margin) to manage.

    Now, how do you allocate your portfolio with all those accounts?
    And, above all, how do you manage to get decent dividends with index funds only?

    Thanks for any insight!

  8. Jon on April 4, 2016 at 5:05 pm

    Always a great to read your commentary. I’m new to investing, but have been sold on the index concept since day one. I read about your two-fund approach. Do you have a particular broker that you go through to purchase Vanguard ETFs?

    • Echo on April 4, 2016 at 6:01 pm

      Hi Jon, thanks for the kind words. My portfolio is held at TD Direct Investing.

  9. Peter Crisp on April 4, 2016 at 6:27 pm

    Great article! It’s rare that I read an article that truly makes me go ‘ah’. I’m pretty good at math but no one has ever explained that the results are skewed – a few stellar funds (and these are often short-lived), a clump skewed at roughly the top third, and a long tail of ‘losers’, which can also be last year’s stellar funds. I simply hadn’t given it much thought. I still use traditional advisors and they are doing a good job, but it’s not cheap and this has me seriously thinking.

    • Echo on April 4, 2016 at 8:47 pm

      Hi Peter, thanks for your comment. One day investors will look back and wonder why they paid so much for the promise of outperformance when they could achieved 6-8% a year and paid a small fraction of the cost. Truly one of the industry’s greatest deceptions.

  10. My Own Advisor on April 5, 2016 at 12:13 pm

    Good post Robb. I prefer to speak about indexing from the perspective of earning market returns less minuscule money management fees; not average returns.

    On the note of being average, XIC ETF has returned about 4% over the last 10 years. Not great but I suspect it’s better than most Canadian DIY investors invested in higher priced investment products. I’m above the XIC pace, for now (I’m paying no fees to hold my stocks) but for how long, we’ll see right??

    🙂

    Keep up the great work. Always fun to stop by your site.

    Mark

  11. Jason Brand on April 8, 2016 at 7:36 pm

    The problem with most index funds is that they are market-cap weighted, despite which I have a couple with 100 or so (not 500) in them. More recently, some have appeared that are (more or less) equal-weighted, and it’s those that have my attention for such a time as I wantr to increase my stock allocation.

  12. Richard on April 9, 2016 at 9:49 pm

    Great viewpoints here. Unfortunately a lot of them are so counter-intuitive that it’s hard to explain them let alone get people to buy in. I like to explain how indexing gets you the results of all the best managers in the world while someone else pays their salaries.

    Just the other day I was helping a friend review his finances and found that the funds he owned had a total return of 15 – 20% over the last 7 – 10 years. My index portfolio hasn’t been doing 20% per year but it certainly tops that.

  13. Albert on May 4, 2016 at 5:35 am

    Someone has thrown in the towel and is now trying to rationalize their decision through this blog. Fine. You take your average-mediocre returns and be happy with them because you and your fellow bloggers can’t do any better. Why? Bloggers may be good writers but most are not so good stock pickers. So please don’t try to convince us that index investing is not the height of mediocrity, regardless of all your convoluted but ultimately specious arguments.

    • Grant on May 4, 2016 at 12:12 pm

      Albert, you seem to have missed the whole point of the post. Indexers do not get average returns, they get market returns – a huge difference. It so happens that market returns are way above what the average investor gets, or what you call average-mediocre returns. You might be interested in this article.

      http://www.evidenceinvestor.co.uk/wheres-the-evidence/

  14. Curt on May 4, 2016 at 8:31 am

    Hmm, Albert offers an interesting “throw down”. I wonder if his 10 year portfolio supports his assertions.

    Albert, start a blog with real facts and dollars, and lead us into the light that some many of us have failed to find. Meanwhile I will enjoy the life of an “Indexer”.

    Robb, keep writing and making sense.

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