For approximately 85 percent of individual investors, their investment goal is to “beat the market.” If you are one of those investors, I want you to consider abandoning that goal and making a new one. Instead, try capturing market returns for the asset classes in which you invest.
Poor historical returns
By some estimates, over the 20 years from Dec. 31, 1993 to Dec. 31, 2013, the average investor earned a little more than 2 percent annualized.
Let’s put this puny return into context. The average investor underperformed every category except Asian emerging markets and Japanese equities. These returns even underperformed three-month Treasury Bills, which are essentially risk free.
This data yields only one conclusion: By seeking to “beat the market,” the average investor is significantly underperforming market returns.
So who is benefiting if not investors? Brokers and much of the financial media, who spew out a daily barrage of misinformation that causes investors to run up trading costs, chase returns and engage in other short-term behavior harmful to their financial well-being.
Market returns would be a huge improvement
Based on historical data starting in 1928, the long-term stock market return is approximately 9.6 percent, which includes dividends.
Don’t be confused by that number. Over the past 89 years, the S&P 500 index has never delivered a total return of exactly 9.6 percent in any single calendar year. It has always been higher or lower, but the average comes out to 9.6 percent. It can be a bumpy ride.
By simply capturing market returns, using low-cost index funds, your long-term annualized returns would have been about 9.6 percent compared to a little more than 2 percent.
Capturing market returns is not “average”
Brokers often deride index-based returns as “average returns.” The reality is that evidence-based investing, using low-cost index funds, exchange-traded funds or passively managed funds, does not give you average returns. They produce above average returns. Here’s data your broker doesn’t want to know.
In their book, The Incredible Shrinking Alpha, my colleague Larry Swedroe and Andrew Berkin looked at the performance of index funds from two of the leading fund families, Vanguard and Dimensional Fund Advisors. A problem with data comparing the performance of index funds to the performance of actively managed funds is that it typically doesn’t take into consideration “survivorship bias.”
Reliable studies have demonstrated that only 54 percent of actively managed funds survive a 15-year period. Typically, liquidated funds had poor relative performance, a lack of commercial success or a combination of both.
Even without taking survivorship bias into account, seven Vanguard index funds covering different asset classes beat the returns of 70 percent and 49 percent of actively managed funds over 10- and 15-year periods. If survivorship bias was accounted for, it’s likely the 15-year rankings for the Vanguard funds would have been significantly higher.
The Dimensional funds performed even better. They had average 10-year and 15-year rankings of 22 percent and 23 percent. These funds outperformed 78 percent and 77 percent of the surviving funds.
Show this data to your broker the next time he tells you that index-based investing is for those who want “average returns.”
The past three years
The past three years, ending Dec. 31, 2014, should give you pause. If you simply bought an S&P 500 index fund on Jan. 1, 2012 and sold it on Dec. 31, 2014, you would have had a return of 74.60 percent, which assumes dividends were reinvested.
I am not suggesting that investing 100 percent of your allocation to stocks in an S&P 500 index fund is suitable for anyone. Most competent advisors would recommend investing in a more broadly based domestic index fund (like one that tracks the Wilshire 5000 index) and including international stocks.
Nevertheless, it’s significant that investing in a simple S&P 500 index fund over the past three years produced returns of this magnitude. I suspect relatively few investors who were trying to “beat the market” achieved these returns, or anything close to them.
My final argument
If you seek to “beat the market,” sometimes you will succeed, but it is more likely (especially over the long term) that you will underperform. If you change your goal to capture market returns, they are yours for the taking. You can achieve those returns, less the low cost of the index funds in which you invest.
Of course, obtaining market returns works both ways. When the market is up you will benefit. When it goes down, you will incur losses. You need to be sure your asset allocation (the division of your portfolio between stocks and bonds) permits you to withstand the inevitable market corrections.
Now is the time. Don’t wait. Abandon your often futile efforts to “beat the market” and start capturing market-based returns.
This commentary originally appeared February 24 on TheHuffingtonPost.com
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