There are 5 key reasons passive ETF index investing works
- Investors as a group are destined to be average
- Costs matter
- Broad asset classes tend to have long term upward trends
- Index investing is tax effective
- No way to differentiate between luck and skill
Investors as a group are average
The reason index investing wins, is fairly simple and you don’t need to be as smart as Warren Buffett to understand it. As a group, investors are destined to be average. Or in other words if one person wins another one must lose; in much the same way 93% of US drivers think they are above average, obviously they are not, they can’t be. Time and time again studies have shown in investing terms if you are prepared to admit you might not be better than average, you will end up far better off than the average.
….in much the same way 93% of US drivers think they are above average, obviously they are not, they can’t be…
Essentially the way it works is that after costs investors as a whole must under perform the market. It is impossible for them not to.
Index Fund Costs
Another reason it works is that your costs are very low and this matters over a long period of time, it matters a lot. Total costs of actively investing are estimated to be worth around 2% of your return.
Any benefits of active investing (outperformance of the market) tend to exceed the cost of active investing (transaction and trading costs, fees, and stock-specific risk issues). Well more than 50% of active managers underperform the passive strategy BEFORE costs. So even if you can identify an above-average active manager they still have to jump the hurdle of their own costs to deliver an index beating performance AFTER costs.
For example, total annual fees and costs of 2% of your investment balance rather than 1% will reduce your final return by up to 20% over a 30 year period (for example, reduce it from $100,000 to $80,000).
This article by John Bogle shows in more detail how even after adjusting for risk, low expense funds have far higher returns than high cost ones.
The beauty of passive investing in index funds is it’s exceedingly difficult for an investor to make a long term investment in a broad asset class that does not have a long term upward trend. For example consider the American stock market; it has many of the largest, most successful and dynamic companies in the world, why not take a punt on them all? Sure there are some duds in there but over the long term its been a very safe bet the winners will more than make up for the losers.
The simple fact of the matter is that most broad asset classes have long term upward trends.
Index funds buy and sell stocks a lot less frequently than actively manged funds. Because of the low level of stock turnover in index funds, they are more tax effective than actively managed funds which realise capital gains and loss more frequently
Differentiating between luck and skill
There is no doubt underpriced stocks can at times be identified – it’s just that there is little evidence to suggest many if any people at all can do it reliably over a long period of time.
Differentiating between luck and skill is not easy to prove. John Bogle uses the example of a room full of people tossing coins. After each round of tossing anyone who did not toss the same as before (for example two heads or two tails in a row) has to sit down. Provided you have enough people in the room there will always be someone who has defied the odds and tossed all heads or all tails.
To put it another way picking a fund manager based on their past track record is pointless and there is tons of empircal evidence to prove it.
A study by Larry Martin (1993) estimated the probabilities of active managers outperforming an index after taking into account the overall cost impact of active investing. These are shown in the table below:
|Investment Period (Years)||One Manager||Multi-Manager(Three Managers)||Multi-Manager(Five Managers)|
In other words if you chose one active manager to manage your investments, your portfolio has on aggregate only a 22% chance of beating the market index over a ten-year investment period. And the probability gets much worse for longer investment periods.
Put simply all this adds up to the idea that when measured over the long term it is very difficult for active investment managers to outperform the market.