0

It's a frequent assumption, here by Burton Malkiel:

It’s true that when you buy an index fund, you give up the chance to boast at the golf course that you picked the best performing stock or mutual fund. That’s why some critics claim that indexing relegates your results to mediocrity. In fact, you are virtually guaranteed to do better than average

Why is buying at the market price (ala index funds) "virtually guaranteed" to do average? Are there any cases where it doesn't hold true? I feel like the answer will be something based on the Efficient Market Hypothesis, but not sure where to look.

Edit: I know from fees, taxes, etc. that you'll do better than average, but I am unconvinced on the underlying "equal to average" statement.

Nolan Hergert
  • 39
  • 5
  • 2
    Welcome to Lake Wobegon, where all the children are above average. – Pete Becker Apr 17 '19 at 11:56
  • @PeteBecker: Of course, "all are above average" is universally (at least for a non-empty set) impossible, while "more than 50% are above average" is completely feasible depending on which average (arithmetic mean, geometric mean, median, mode, something else?) is being used. – Ben Voigt Apr 17 '19 at 17:56
  • @Nolan: Are you claiming that the arithmetic mean investor equals the market average, or that the median equals the market average? Both cannot be true, since mean > median when the tail is long as it is for the population of investors. – Ben Voigt Apr 17 '19 at 17:59
  • @PeteBecker - As a lifelong fan I corrected your mis-quote. – JTP - Apologise to Monica Apr 17 '19 at 20:40
  • The question is unclear: "Why is the average or median investor always the market price?" The average investor does not get the market return, if that's what you meant. The quote you included suggests the opposite, saying that by getting (close to) the market return you beat most investors. – Earth Apr 17 '19 at 21:19
  • @BenVoigt I am not sure what to claim, other than trying to understand Malkiel's quote. Just throwing out some ideas on what average he meant. I will edit the question to be more clear. – Nolan Hergert Apr 18 '19 at 03:19
  • This question is very, very confused. the phrase "buying at the market price" has utterly no connection to "a la index funds". – Fattie Apr 18 '19 at 13:05
  • taxes, fees etc have no relationship whatsoever to the fact that simple index funds, thrash all stock pickers. – Fattie Apr 18 '19 at 13:06
  • Also TBC "the Efficient Market Hypothesis" has absolutely no connection at all to the fact that (observably) stock pickers are (observably) utterly, totally useless. – Fattie Apr 18 '19 at 13:11
  • @Fattie Care to provide some references? Index funds are by definition trying to track the market index, so I don't think they can use a limit order. They'd have to use a market order (whatever price the market will sell at). Also there have been several very profitable fund managers and hedge funds over the years. Not that we could pick them ahead of time, but folks like Renaissance do exist. In general though, I agree with you it's difficult to beat the index individually. – Nolan Hergert Apr 28 '19 at 04:36
  • @NolanHergert - as you say there have been "several" profitable funds, like, 1 in a 1000! The fund industry is a simple scam, writ large. A company launches many funds. Randomly one gets good results for a year or two, so they run lots of ads for it (and just quietly dump the others). It does seem to be the case that the simplest stock picking strategy - "the biggest companies" (that's all "index funds" are) seems to work best, or is the only thing that works. (BTW I'm sorry, I simply don't understand what you mean about limit orders etc.) – Fattie Apr 28 '19 at 13:28
  • @NolanHergert , I just want to express again: in your headline: if I understand your sentence, you believe that "market prices" (what does that even mean? The "market price" is just the last price recorded for some particular stock; it's unclear whan you have in mind there) ... you believe that "market prices" (again - "?") have some relationship to "index funds". The concepts are totally unrelated. An index fund is, simply, a fund that (instead of "some guy picking stocks") simply buys the stocks in the S&P or whatever "index". Note that... – Fattie Apr 28 '19 at 13:31
  • ... the "index" (eg S&P index) is simply a list of "the biggest companies", nothing more than that. – Fattie Apr 28 '19 at 13:32
  • @Fattie I think we agree on point #1. On #2, from what I understand the s&p 500 index is the combined prices of the most recent transactions for each company in the index. If you have money coming into an s&p 500 index fund, the fund needs to purchase shares. At what prices? The most straightforward way to maintain accuracy to the underlying s&p 500 index is the lowest prices you can buy them for ("market order") since that's what is tracked by the index anyways. If you waited for a particular price (limit order), then your order might not get filled and you wouldn't track the index. – Nolan Hergert Apr 28 '19 at 15:25
  • @Fattie I hope this explains the explicit linking that I had in mind. – Nolan Hergert Apr 28 '19 at 15:31
  • @NolanHergert , hmm, regarding the actual moment-to-moment trading executions of the traders/caretakers who run Index Funds .. I have no clue (and I don't know, and it doesn't matter - at all) how they buy and sell stuff. It's actually (I happened to read an article on it once) not "that" simple to run an index fund; you have to (apparently) do careful magic when stocks go in and out of the fund etc; as you perhaps imply there's no "utterly pure" way to buy/sell "the index"; it would be a bit of an approximation. .... – Fattie Apr 28 '19 at 15:51
  • (Just for example, merely one issue, you wouldn't have precisely the exact ratio from moment to moment.) Note that all of this also applies to other funds (ie run by fund-pickers .. the useless ones that very rarely outperform plain index funds!!) I don't know, and it's of almost no consequence, whether as a day to day mechanical matter they use ordinary orders, place stops, or whatever. the day to day mechanics of whether you use limit orders etc has zero bearing on a fund. – Fattie Apr 28 '19 at 15:54

5 Answers5

5

This is a graphic from the Vanguard article @timday referenced.

enter image description here

The article itself uses the term zero-sum in a way that's not common, but I'm ok with it, once understood. Note, for the question Is it true that 90% of investors lose their money? I open by saying

The game is not zero sum. When a friend and I chop down a tree, and build a house from it, the house has value, far greater than the value of a standing tree. Our labor has turned into something of value.

In hindsight, I stand by this brilliant quip. But I'm also open to how others use the term. Here, what Vanguard is saying is that in any given year, the market as a whole will have a return. If you believe the S&P is not reflective of 'the market', use a broader index, such as the Total Market Index Vanguard offers. The random nature of tens of millions of investors produces a curve of returns. Some see a higher return, some lower.

The point that Jack Bogle ('father' of index investing) had was that the average investor in mutual funds saw a return that had a cost, typically 1% or more, and that meant that even a good fund manager would have a tough time even matching the market return.

His approach was to drive index investing down to where anyone could invest for a return of S&P less .05% or so. My own retirement plan (along with my wife's) is in VIIIX, which charges .02% per year. This is $200 per million invested. vs $10,000 for funds charging 1%. The graphic shows that in any given year, far fewer than 50% will match the average, as the 'zero sum' is total market return less fees, and fees over the year will drag the average investor return down below market return.

Lest anyone cite some fund that's beaten the market over X years, that's great, what about the rest of them? And what of the thousands of funds that lagged and are closed now?

JTP - Apologise to Monica
  • 172,273
  • 34
  • 296
  • 560
  • Great answer, but I am trying to focus just on on this part: The random nature of tens of millions of investors produces a curve of returns. Some see a higher return, some lower. – Nolan Hergert Apr 18 '19 at 04:55
  • Joe, I feel there is some confusion. Let's utterly set aside any trading costs. (And totally forget about any issues of what zero-sum means or doesn't mean.) A simple index fund (which is nothing more than "the biggest say 100 companies") thrashes 99.999% of human stock pickers, particularly in the long run. This is the reason why "index funds beat stock pickers" (ie, because observably stock pickers are useless). As I understand it this is what th OP is asking. – Fattie Apr 18 '19 at 13:09
  • 2
    Fattie - if trading costs were zero, and no manager fees at all for any money managers, it would seem the curves presented above would be identical, the left shift is the cost of transactions. There would be good traders/investors and bad, but take the average return and divide it over the population, and average is average. – JTP - Apologise to Monica Apr 18 '19 at 13:21
  • @NolanHergert - if you look at the returns of mutual fund in any given year you will see a range of returns clustered about the market return, but when averaged out, just a bit lower due to cost. Please help me understand what's not clear. Perfect bell curves don't quite exist in most real life situations, but they are the best way to illustrate the phenomenon for sake of discussion. – JTP - Apologise to Monica Apr 18 '19 at 13:25
2

Because investing is a zero-sum game. For every investor beating the average market return (which is what the index gets you), there are others under-performing it by an equivalent amount. Cheap index funds let you invest in that average pretty much "for free" (or near enough) these days. Doing something else is usually more expensive in charges, and without a way of predicting which managers and/or strategies will outperform in future it's a coin toss whether you'll do better or worse than the average (and that's before those higher costs are considered).

See also Vanguard's "What's the zero-sum game?" article saying much the same thing.

timday
  • 3,927
  • 13
  • 30
  • Uh, maybe you folks should put up your own answers? – timday Apr 17 '19 at 16:56
  • 1
    Yes. They should. No new comments on this answer, Please. – JTP - Apologise to Monica Apr 17 '19 at 20:19
  • The issue of whether the "market" is a zero-sum game is very confusing. (1) almost nobody even understand the phrase (2) when you talk about the local in time market that is utterly different from the macroscopic market. (3) There is vast, vast confusion between the issues of "stocks" which is one thing and "company 'values'" which is another. Regarding the macroscopic market (i.e. over decades), on the contrary to being a "zero sum game", the long-term market *is very simply a ponzi: more and more people put in* money every year, every generation. – Fattie Apr 28 '19 at 13:35
2

Your question starts with a wrong premise....

In fact, you are virtually guaranteed to do better than average

That is fundamentally different from your question.

Why is the average or median investor always the market price?

The market price, according to your quote (and all the stats I've seen) is doing better than the average investor.

Your question is unclear, but I think the gist of it is why is everyone measured against the market. And the reason is that that's all anyone cares about.
So you got 10% ROI on your investments ? that's great, but the market rose 15%....
So you got 5% ROI on your investments ? That's amazing when the market went down 30% over the same time.

xyious
  • 2,778
  • 9
  • 15
0

The premise of market indexes beat 50% of investors is a way underestimate. The real number is well over 90% closer to 95%.

Where I am from that is more than good enough an answer, but I can see how that is less than satisfying.

So allow me to elaborate.

Actively managed funds (by professionals) rarely beat the market over the long term (5-7 years). In fact, they rarely beat a monkey with a dart board.

Why?

Warren Buffett actually explained it really well.

https://www.youtube.com/watch?v=ioLRnGXZt8A

The simplest reason is, modern portfolio theory.

For an individual investor, having one great investment idea is HARD. Even with a team of professional, having 3 or 4 great ideas a year is very difficult. Warren Buffett said there were years he bought nothing because there was just nothing to buy.

And notice, the more positions you have, the more companies and business sectors you will need to follow.

It is essentially impossible to have that many great investment ideas, and even more impossible to track them all.

But modern portfolio management theory says, you MUST diversify.

Logic dictates, the more you diversify, the more duds you would have.

BUT unfortunately, your funds are limited. So no matter how diversify you are, you would never be as diversify as the market.

But wait, there is an even worse part of the theory, which says you should take profits just because it has gone up "too much" ... This leads to the bizarre scenario where people sell the winners too soon, and hold the losers too long.

As a result, by adhering to the modern theory of portfolio management... almost nobody beats the market.

And finally, the market is not the median of investors.. the market is all the stocks......

JTP - Apologise to Monica
  • 172,273
  • 34
  • 296
  • 560
sofa general
  • 571
  • 2
  • 6
-1

I want to thank the other answers for pointing me in the right direction.

I found Index Investing Makes Markets and Economies More Efficient on Philosophical Economics an excellent overview and a welcome improvement on Sharpe's terse article, The Arithmetic of Active Management. I will summarize below, but please refer to the original above for more details/caveats.

For an experiment lasting one year with many idealized assumptions, assume two groups of investors, passive and active. All passive investors will always get the market return (the real underlying change in price) because they are not offering their shares up for sale until the end of the year. Active investors as a group will also only get the market return because in the end, all their shares will have the same price on the open market. Therefore, the active investors are playing a zero-sum game (after subtracting the market return) because they have to buy and sell between themselves. For one active investor to outperform the market return, another active investor has to sell them those shares (at an eventual loss).

The market return (which every passive investor is getting by default) can then be thought of as the weighted (by investment size) average of the returns of each active investor, which sounds a lot more appealing than saying the "market return". E.g. "I beat half of the actively invested capital on the market by doing nothing, and that's even before management fees!"

The article also does a great job of explaining the caveats and showing how in practice they end up not mattering that much.

Nolan Hergert
  • 39
  • 5