Few of us like to admit we are merely average in some respect. You’ll hear commentators say that anyone who is just an average investor would be better off owning low-cost index funds. Curiously, it is both indexing proponents and detractors who say this. Digging deeper into the meaning of “average investor” gives some insight the value of index investing.
We often hear proponents of active stock-picking or market timing say things like “indexing is fine if you’re just average,” or “why would you want only average returns?” On the other side of this debate, Dave Nadig wrote “you have to accept that you, the investor, are not a special flower. You have to accept that you, the investor, are average.”
I see little hope of convincing overconfident stock pickers and market timers that they are merely average until we define “average investor.” After all, I’ve met many of my neighbours. I’m willing to bet that I can comb through companies’ financial statements better than most of them can. Doesn’t this make me above average?
An important thing to understand about the competition among stock pickers is that the average is dollar-weighted. This means that if you have more money than someone else, you contribute more to the average skill level in the stock market.
If I have a $100,000 portfolio, then someone with $200,000 contributes twice as much to the average as I do, and someone with $50,000 contributes only half as much. This may offend our sense of democracy, but it is the reality of competition among stock pickers.
What about a mutual fund controlling $10 billion? They count as much as 100,000 people with $100,000 each to the average of all stock pickers. When your neighbour hands his money over to a mutual fund, his stock-picking skill no longer counts in the average; his money just makes the fund’s managers count for slightly more in the average.
When your other neighbour sticks to index investing, he has taken himself out of the average as well. People only count in the average skill level of stock pickers to the extent that they are actually picking their own stocks.
So, your competition isn’t really your neighbours. As an active investor, you’re really competing against an army of professional investor dollars and a lesser number of individual investor dollars. To a first approximation, the average investor is a professional money manager.
You don’t have to admit that you’re merely an average investor among your friends and acquaintances to embrace index investing. You just have to admit that you’re not better than investment professionals. And even if you are better than the pros, you have to be better by enough to make up for the higher costs of active investing.