“Odds are you don’t know what the odds are.” —Gary Belsky and Thomas Gilovich, “Why Smart People Make Big Money Mistakes”
Rule number one for spending your hard-earned dollars—pay for value. This rule is so obvious that it’s almost offensive to mention. When you plop you body down at a Motel 6 for a quick sleep while on the road, you don’t expect to get the Ritz Carlton. And few will complain of spending top dollar for an unforgettable dream vacation spent celebrating one of life’s precious milestones with the ones you love. You work hard for your money and when you spend it, you want value commensurate with cost.
Yet in a macabre twist, millions of retirement investors line up ever day and pay Wall Street to take their money. As ridiculous as this sounds, the facts overwhelmingly and conclusively demonstrate that actively managed money significantly underperforms passive investing over time.
The perfect business model
To put this in context, think for a moment about how corporate boardrooms as well as Silicon Valley start-ups are filled with the same vigorous discussion: how to offer products and services of value to customers that will result in increased market share and profits. While real companies compete to improve their goods and services, the financial industry has pulled the ultimate business coup: They have discovered the perfect business model in which people pay for them to simply take their money. Sound absurd? Take a look at the facts.
In Rick Ferri’s recent book, The Power of Passive Investing, the ineffectiveness of active money management is reviewed going back as far as 1930. As Ferri points out, Nobel Prize winning economists of the likes of William Sharpe of Stanford University and Jack Treynor of MIT; leading researchers like Eugene Fama, Harry Markowitz of the University of Chicago, and Burton Malkiel of Princeton; and the popular writings of John Bogle and many others have all demonstrated that after expenses, active management is a fool’s bet. A study by S&P showed that over a five-year period, nine out of nine equity fund categories underperformed their corresponding passive indexes.
Why does active money management underperform, you may ask? The reason is quite simple: It costs too much. Most active fund managers have to beat their benchmark index by 1-2 percentage points each year just to break even on an after-expense basis. A performance improvement of 2 percent may sound small. But when we remember that the total stock market’s long-term return is only 8-10 percent, it starts to become clear why so few funds are able to perform such a feat over any extended period.
And for some investors, the bad news does not stop here. For instance, investors may turn to advisers who, according to a recent study, charge an average of 1.1 percent annually for further disservice. The net can be devastating. A 2.5 percent fee drag over 20 years can mean retiring with as much as 40 percent less compared to an investor who stayed the course with a passive portfolio. And don’t count on trying to have an honest discussion with your adviser about these facts. As John Bogle, the founder of Vanguard, once said, “It is amazing how difficult it is for a man to understand something when he is paid a small fortune to not understand it.”
How to be the 1 percent
Here is another shocking fact: A study performed by DALBAR, Inc. compared the average investor’s returns with the returns of the S&P 500. Investor returns are quite different from the index’s returns. Why? Because investors, often at the behest of their advisers, buy and sell funds due to such things as market swings or the never-ending search for the next, hottest five-star fund. The study looked at the S&P 500 from 1987 through 2007 and found an annualized return of 11.81 percent. The average inventor’s annualized return for the same period was a shocking 4.48 percent, more than a 7 percentage point difference, or what has been described as the behavior gap.
The problem of active money management is a multifaceted nightmare: money moving in and out of funds, unnecessary and unwanted tax friction, and fees upon fees. Why does any sane investor sign up for such abuse? Those in the know continue to wonder.
Possibly the cause is rooted in the astute advertisements run during the Masters, British Open, U.S. Open, and beyond that get your investment account open and your mind closed. Critical thinking skills can be whisked away by multi-million dollar marketing campaigns targeted to cast their spell. Once an investor buys the commercial rhetoric, a hypnotic trust can hijack critical thought. The hypnotizer can get the otherwise astute subject to perform the most ridiculous behavior, such as paying someone to take his money.
The only hope for the hypnotized investor is that actual facts will provide a benevolent snap of the fingers, awaking the subject to investment realities. By buying and rebalancing a diversified indexed portfolio over decades, you can escape the active management madness, leave the behavior gap behind, and find yourself in the top 1 percent of investment returns. In the end, paying yourself is much better than paying others for nothing.