It is one of the great myths of American investing that out there, somewhere, is a genius of a financial investor, who, for a very small fee will invest your money so wisely that you will earn a huge return and become very rich. The fallacy of this dream should be so evident that no rational investor ever believes it, but alas that is not the case. The myth persists.
The great beneficiaries of this myth are those investment managers who make huge fortunes investing other people’s monies, usually with the result that the investments earn less than what a person randomly picking stocks would earn or less than what a person investing in a fund that simply matched average returns would earn. The leading myth buster is John Bogle, who founded the Vanguard family of mutual funds with low management fees, and who developed the index fund with a very low management fee.
Mr. Bogle is in the news again now, with a new book, which will be about as widely dismissed as his old books.
Mr Bogle is now 83, and his latest book* echoes many familiar themes (he even reprints a section of this column). But those themes are worth repeating, because they are too often ignored. Investors spend so much time chasing hot asset classes and hot fund managers that they end up buying high and selling low, all the while incurring transaction costs. In Mr Bogle’s words, “investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.”
So what’s the problem here? It is this, fees for managing accounts and for transaction services are high, meaning that an investor has to be above average in order to be average. That is, gross returns need to beat the market because the costs of investing are taken from the investor before they get their net return.
Mutual funds turn over their portfolios more frequently than in the past. They are also more volatile. Neither attribute seems particularly beneficial for their clients. The proliferation of new funds lures investors into chasing star managers—with disastrous results, since investment performance tends to revert to the mean. Between 1997 and 2011, the average equity mutual fund returned 173.1%; the average investor (weighted by dollars invested) earned just 110.3%.
So why doesn’t the typical investor just invest in the index fund which mirrors the market as a whole and has a very low fee? Because that means denying the dream, puncturing the fantasy and recognizing that no, you are not going to get very wealthy by doing better than the average in the stock market, because if you pay huge management fees you are going to do worse than the average.
Meanwhile, many employees in the private sector have been switched into defined-contribution schemes, where their retirement income is dependent on investment performance. But employees are not saving enough, are not allocating their portfolios efficiently and are incurring too many costs. It is hard to disagree with Mr Bogle that the “system of retirement security is imperilled, heading for a serious train wreck.” But will anybody listen to him, when they haven’t in the past?
Dreams are powerful stuff. Demolishing them takes more than experience, data and empirical results. It takes rational, objective people. And they are largely missing, which is why people who manage money for a living do very well.