We’ve all heard about market averages. In the US, the big ones are the Dow-Jones Industrial Average, the S&P 500, and in Canada, we have the TSX. There are many other stock market averages as well.
However, most investors get significantly worse results than these averages. There are many reasons for this: paying higher brokerage fees, paying high fees to investment advisors, paying high taxes due to overtrading, etc.
Even when investors buy index funds that are designed to track a market average, they often underperform the average because of failed attempts to time the market; in trying to avoid market drops, they miss market increases.
For these reasons, I think that “market averages” are misnamed. If you buy a stock index and hold on for two decades, you will get much higher than average results.
Another problem with the word “average” here is that it turns off investors. Who wants to be average? Who doesn’t think he can do better than average? Maybe we should call the returns of indexes the “index high bar”.
Some people would still try to beat the high bar, but most could comfortably say at a party “I decided to take the market high bar and devote my free time to other pursuits rather than evaluating stocks all the time.”
One weird thing about indexes as benchmarks is that nobody can literally buy the index so why benchmark against it? In my opinion a stock picker should benchmark against ETFs because that is what one can actually buy.
ReplyDeletemg: I suppose that someone with a huge portfolio could buy an index, but this doesn't apply to the vast majority of investors. The tracking errors with the good index ETFs are much smaller than the amount by which the average stock picker will underperform. So, I agree that bechmarking against a good ETF makes sense, but I don't think it will save many investors.
ReplyDeleteETF's sound good but what if you are poor like me and can only invest a little bit each week? The only choices I have are mutual funds or buy TD e-series funds.
ReplyDeleteSeems like the ETF's are for those who already have large liquid portfolios. ETF's have commissions at the point of buying and that's really too costly if you contribute a small amount of money 2 or 3 times a months from your paycheck.
Alot of investors and savers, in fact a majority I would guess, invest a 10% or 5% of their paycheck every two weeks. ETF's are out of the question for these types of investors until they build a large portfolio.
Henchman:
ReplyDeleteYou're right that for smaller portfolios you need to consider all costs carefully before choosing the right way to invest. Here's hoping that your portfolio grows to the point where you can buy ETFs economically.
I agree. Something like 75% of all actively managed funds underperform the associated index. The term "average" shouldn't be used at all around any of this.
ReplyDeleteMJ, your point is well taken. The preceeding discussion suggests the best term might be the "market benchmark".
ReplyDeleteThose of us who hold passive index ETFs could talk about beating the "fund average"since it is always much worse than the market benchmark, though we never quite achieve that goal either due to the aforementioned tracking error.
"Even when investors buy index funds that are designed to track a market average, they often underperform the average because of failed attempts to time the market; in trying to avoid market drops, they miss market increases . . . If you buy a stock index and hold on for two decades, you will get much higher than average results."
ReplyDeleteI think your reasoning that the performance of the "average" investor is somehow worse than the index itself is wrong. If you buy an index and hold on to it for two decades your performance will match the average performance of all investors (neglecting MER and commission).
When I sell an index fund at $100/share (which I previously purchased at $150/share) there is someone else who sold it to me at $150/share and is now buying at $100/share. At the end of the day, someone who only bought and sold an index fund should get the same performance as the index (neglecting commission costs).
It's a zero-sum game, except the sum of everyone's performance isn't zero. Instead the sum is the market index's performance.
Jim Somerville, the only reason mutual funds underperform indexes is because of the MERs. Most mutual funds have MERs of at least 2% which means that they will, on average, underperform the index by that amount. The reason mutual funds underperform is not so big a mystery as many people make it out to be.
ReplyDeletecanadianinvestor: do you know much tracking error actually is an how much is actually affects long-term returns? Please provide some numbers.
Dave: Your reasoning about the market being a zero-sum game breaks down when you consider that many investors have some or all of their money out of the market at various times in (mostly) failed attempts to time the market. Over a long period of time, the investor who stays fully invested in an index will outperform most other investors. Other factors that make this true are that other investors tend to pay more in fees and taxes from all the buying and selling.
ReplyDelete