Thursday, September 22, 2011

Different Approach to Explaining Index Investing

The math says that before costs, index investors must get the same returns as the average active investor. But, index investing has lower costs giving the edge to index investors. Because most active trading is done by professional investors, it’s not surprising that the evidence says that after costs indexing will outperform investing with the average professional. But few people understand this. Most people will never believe that they can get better returns than a brilliant professional can. After all, professionals in almost all other fields do better than amateurs.

But what if there was a way to get advice from not one or two, but all professional investors? We could have all the professionals in the world get together and average out their best picks. Most people would be more than happy to follow this collective advice from the best investing minds. But how could we possibly convince all the professionals to get together like this?

Of course we can’t, but this is a trick question. It turns out that the index is the (weighted) average of all professional investors’ best picks. Buying low-cost index funds is like hiring every professional investor in the world, but only paying for a small fraction of one of them.

10 comments:

  1. Indexing does not "beat" the average professional, because pros' transaction costs are lower than the MERs on index funds and ETFs.

    Moreover, your index is not just the average of all pros; it is also the average of all amateurs.

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  2. @Dale: I can't tell if I was unclear or you are deliberately misunderstanding me. In any case, indexing beats an investor's access to pros which only comes with costs. It doesn't matter to me whether a pro can beat an index if my ability to invest with the pro unltimately gives me lower returns than the index.

    Amateur trades are swamped by professional trades. Amateurs make little difference. The gap between the index and the average of the pros is very small -- certainly smaller than typical MERs.

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  3. "It turns out that the index is the (weighted) average of all professional investors’ best picks"

    Yes. But stock prices also include the best picks of every individual investor - and their track record is dismal.

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  4. Thank-you for your clarification on your meaning of "professional" as a fund manager.

    I agree that few managers consistently beat indexes. However I disagree that amateurs "make very little difference". Retail investors and amateurs that follow indexes such as yourself are becoming more significant over time.

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  5. @Dr Rathgeber: Index investors, by definition, make no difference to the index.

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  6. @Mark: It is true that amateur investor results are dismal. But nonprofessionals make up a small fraction of overall trading volume. The bulk of trades are made by the pros.

    @Dale and @Patrick: I agree that the trend to indexing is growing, but this fact hasn't helped the pros beat the index, as Patrick pointed out.

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  7. It sounds fun to tell people that they're paying for the advice (with up to half their portfolio or more in the long term) while you're getting it for free :)

    Of course if you give someone this argument their first response will probably be "yes, but what if you take out that one manager over there - the really bad one that no one would ever invest in except those suckers who gave him $8B? then you would have better returns!"

    As for the debate about market impact, I doubt evening stock pickers make up a significant volume of trading but a large part of the professional managers' assets come from individuals who may decide to sell their stock funds at the worst time. Even institutional investors (professionals giving money to professionals) seem vulnerable to popular trends while using indexes based on those trends.

    This doesn't mean that stock picking adds a lot of value but it does seem to be more common now for a whole market to move without regard to long-term value or individual securities. Index investing likely plays a big part in this.

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  8. Good points by all of you. However, "amateurs" who listen to BNN's constant barrage of talking heads do drag down the index to some small extent. Don't they?

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  9. @Value Indexer: Any time people believe they can pick the pro who can beat the index after costs, there is little left to talk about; if they're right then they should go with the pro. I doubt that people are able to pick such pros consistently, but it's difficult to persuade others on this point.

    @Mark: I'm not sure that bad investors knock down the index much (unless they are bailing out of stocks entirely). Bad investors make it possible for there to be good investors. The more money that underperforms, the more money that is able to outperform.

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  10. This is absolutely brilliant!

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