Would You Like to Outperform 80% of Other Investors?

The obvious answer to the title question is ‘yes of course,’ but only one in five actually accomplishes it. Here’s the fascinating part – anyone can join the elite 20% any time they wish and outperform 80% of other investors as long as the 80% continues doing what they are doing.

By now, it’s widely accepted that most actively managed portfolios, whether mutual funds, private accounts, or hedge funds, fail to beat the benchmarks against which they are measured. Yet most investors continue to chase the goal of market-beating returns, despite the low odds of success.

In his 1998 book Winning the Loser’s Game, Charles D. Ellis compared investing to tennis. He explains that there are two games of tennis being played in the world – there’s the one played by the pros and then there’s the one that the rest of us play. He references a study done by Dr. Simon Ramo which revealed that in pro tennis, about 80% of points are won – the winner of the point intentionally and successfully placed the ball where his opponent could not return it. In the world of “winner’s game” tennis most points do not result by accident or luck, they are won by professional tennis players. The rest of us play a”loser’s game” of tennis where most points are lost. The player who avoids more mistakes than his or her opponent, wins.

In the ‘game’ of investing, individuals (non-pros) “hurt themselves badly, by changing funds. On average, they destroy over 25% of the returns earned by their funds by changing. We don’t have to be experts in behavioral economics to recognize that investors sell funds that have done poorly and buy funds that have done well – all too often way too late in both cases.”

In investing there are examples of elite pros who are able to play a “winning game” by exploiting occasional inefficiencies in markets for profit. But just like tennis, everyone else falls well short. Further when pros who share their talents with the investing public in the form of hedge funds, private funds or mutual funds, they inevitably see their results diluted, if not eliminated, as their investing pools grow to eliminate any efficiency and secrecy they had before.

Active management is a loser’s game for the individual investor (and for most professional investors). Studies show that over 10-year periods, more than 60% of actively managed funds fall short of market returns. Stretch that time frame out to 20 years and the number of under-performers increases to 80%. Add taxes to the mix and the story gets even more compelling. A recent study done by Morningstar’s Jeffrey Ptak demonstrates that the average number of actively managed funds (tracked by Morningstar) over 10-year cycles that beat their Vanguard counterparts were just 4.3%!

Ellis sums it up this way: “Today’s market, dominated by expert professionals, is so nearly efficient that almost all investors are not able to do better than the market. So they should focus attention on not doing worse. And that’s why indexing is so sensible and successful. As the familiar saying has it, ‘If you can’t beat ’em, join ’em!'”

Lifetime investing covers periods of 40, 50, 60 and more years. Given that the percentage of active portfolios that under-perform the markets grows with time, doesn’t it seem more prudent to concentrate most if not all of your life-purpose investing in widely diversified low-cost index funds? Don’t you want to outperform 80% of other investors?

Other resources:

Forbes: Five Reasons Your Mutual Fund Probably Under-performs the Market

CBS Market Watch” Here’s the latest failing grade for active funds

Vanguard: The Case for Index-Fund Investing