Wednesday, January 21, 2015

The Average Investor

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.

13 comments:

  1. I'm not an average investor: I'm a "below average" investor. In/Security has its costs.

    I was offended by the bank clerk who announced loudly to his trainee: I don't handle GICs. This was the same schmuck who also announced loudly he had just bought RIM since it was bound to go back up. If he'd bought shares in his own bank, he'd have been a better picker. If he'd bought the new issue of the GIC I was redeeming he'd have been a better picker. If he'd bought the TSX index he'd be hugely, hugely ahead of all of the above. (This was back in 2012.)

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    1. @Bet Crooks: Based on my experience talking to investors, you're the only one who is below average :-)

      One wonders why someone with such strong investing skills would waste time working as a bank clerk instead of investing his own money full time.

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  2. 'Why settle for average returns (the market index)? Because the average return (the returns most people get) is less than that average.

    Average is so convoluted in finance..

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  3. It all depends on the context. If you ask people "do you only want to be an average lottery winner?" they would answer differently. And that's why I'm an index investor. I'm getting something good enough, I don't want to risk losing it all by trying to add a little more.

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  4. Another part of being "average" relates to investor behaviour. A key part of sticking to my investment plan has been removing as many behavioural barriers or other complexities that threaten to sabotage me. In my case, that means limiting the number of accounts/financial institutions I deal with and the number of financial products within those accounts, setting up automatic withdrawals using my TD e-series funds, etc. Make things cheap and simple and avoid getting in your own way. Embrace the average returns that will (hopefully) result.

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    1. @Juan: You're right that to avoid being below average, you need to stick to a plan instead of giving in to panic or greed.

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  5. I wouldn't be offended if someone said I'm below average. I'd also say that so are many "professionals"

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  6. Brilliant! One of the best and clearest explanations I've seen. I'm bookmarking this so that I can quote next time someone says “why would you want only average returns?”

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    1. @Igra: Glad you liked it! This reasoning was an important part of my transition to index investing.

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  7. Excellent post. Too many people have no idea just how out-gunned they really are when it comes to investing. I work for a company with $1 trillion in AUM, and we still do a lot of indexing and often suffer through underperfomance in our active funds.

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    1. @Jonathan: Thanks. I was slow to come to this realization myself.

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  8. In years past, I would have completely agreed with you. And to some extent I still do. But the reason for my change is bubbles. An example is the Japanese stock market bubble. In, 1989, the Tokyo Stock Exchange was 60% of global stock market capitalization with a PE10 greater than 90. That's why I used to be an index investor, but now incorporate value investing also.

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    1. @Anonymous: Well, that doesn't change the fact that the average investor is a pro. You've just decided you know a way of beating the pros.

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