“AH,” yOU’RE THINKING, “an oxymoron for a chapter title.” Nope — I guarantee you’re going to find the numbers and logic that follow very interesting. The math is straightforward but the lesson is profound. And it’s one that receives far too little attention.
When you invest in the stock market, you have two choices: (1) you can buy an index fund or exchange-traded fund (ETF) that matches the market’s returns (boring); or (2) you can try to beat the market’s returns (exciting).
The vast majority of us go with the latter. We weren’t raised to settle for average. We all want to be above average. All of us. Above average.
But that’s a problem. A mathematical impossibility. On average we have to be, well, average.
In other words, the aggregate return of investors trying to beat the market must match the market’s return.
Please trust me here — no matter how boring that statement seems (and it seems pretty darn boring), it’s absolutely key that you grasp it. In fact, it’s so important that I’m going to repeat it: The aggregate return of investors trying to beat the market
must match the market’s return.
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It’s a mathematical certainty. It can be no other way.
We can’t all be above-average investors. The effort to outperform the market is a zero-sum game. There will be winners and there will be losers and they’ll cancel each other out. That will be the case even if all the investors are extremely intelligent.
I’m brutal with analogies, but this one may help drive the point home. If Major League Baseball’s 30 teams are each managed by one of the greatest leaders in the history of the game, col- lectively they will end up with the same record as they would if they are led by 30 little kids who don’t know where second base is. Either way, every game is still going to produce a winner and a loser. The league will play .500 ball regardless.
Let’s look at an oversimplified example of how this ignored truth plays out and why it matters.
Assume there are four mutual funds and each controls one- quarter of the money invested in an imaginary stock market. The first is an index fund that owns every stock on the exchange proportionate to its market value. In other words, it’s matching the market. The second fund is managed by the world’s most famous investor, Warren Buffett. The third is managed by Buffett’s real-life business partner and one of my heroes, Charlie Munger. The fourth and final fund is managed by the brilliant hedge-fund operator, George Soros.
So, 25 percent of the invested capital is happy to match the market and 75 percent, all under outstanding stewardship, is attempting to beat the market.
My mom has $30,000 available and decides to invest it in equi- ties. Here are a few of her options:
(1) She could buy stocks on her own.
(2) She could put the entire $30,000 in the index fund. (3) She could place $10,000 with each of the legendary
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(4) She could put the entire $30,000 with one manager. If Mom opts to go it on her own, she’s crazy. Remember, together she, Buffett, Munger and Soros must earn the same return as the market — the return she can achieve through the index fund. If she hopes to exceed that return, she’ll have to outperform the combined efforts of the three investment geniuses. Frankly, that’s a far-fetched notion.
If she goes for Door #2, buys the index fund and matches the market, she’s guaranteed to tie the aggregate performance of the three gurus, as we’ve learned that performance must also match the market’s return. If Buffett outperforms by 4% and Soros outperforms by 1%, Munger must underperform by 5%.
How cool is that? My mom can kick back, buy a market-matching index fund and keep up with a team of three of the greatest investment minds of all time. This despite the fact that she thinks of stocks only as broths used in soups.
Basic math but still hard to believe, isn’t it?
If Mom elects to split her money up evenly among the three managers — the third option — we all now know what must happen: She’ll match the market and end up in the same posi- tion as she would if she had just bought the index fund. The final alternative, putting the entire $30,000 with one man- ager, might or might not work out well. One or maybe two of the managers will post better-than-average returns and one or maybe two will post worse. Can my mother figure out ahead of time whom to bet on? Can you? Can anybody? Buffett? Munger? Soros?
So to summarize: If my mom invests on her own, my sister and I will need to have a long talk with her. A loooong talk. If she uses an index fund, she’ll earn market returns. If she divides her money up equally among the three financial gurus, again, she’ll
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earn market returns. If she tries to pick the right horse, she might outperform, she might underperform.
Some sharp-minded critics may argue that my illustration is slightly flawed because of subtle nuances like blah, blah, blah, blah, blah. Whatever. Its basic teachings hold true.
To outperform the market’s return, you have to outperform the majority of others who are also trying to outperform the market’s return.
I’ve always been surprised at how few people realize that. When you hand over your hard-earned savings to a professional money manager you deem smarter than yourself, be careful. Because you have the option to buy an index fund and match the market’s return, it’s irrelevant if he or she is smarter than you. Instead, what matters is whether he or she is smarter than most of the other people who are smarter than you.
Sorry, that came out rudely.
Before you move on to the next two chapters, it is imperative that you understand this one. Reread it if you’re struggling. Phone me if you have any questions. yes, I mean it.
And the math is even more fascinating in the next chapter! How can that be? What a page turner!