#290 Stop Trying to Beat the Market: Use Index Funds

Stop trying to beat the market, because you can't. That sage advice comes from investment legend Charley Ellis, who has been keeping tabs on the debate between active and passive investment management for five decades. In his new book “Index Revolution: Why Investors Should Join it Now” Charley argues that indexing is the most efficient and cost effective way to achieve your long term financial goals. He states it clearly: “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.”

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Ellis founded Greenwich Associates in 1972, creating a financial industry consulting firm that would become a go-to resource for the biggest fund managers and Wall Street firms. One of his many claims to fame is that he was the first industry insider to publicly proclaim that most active portfolio managers do not keep up with the benchmarks they are trying to beat, and that investors are better off in low-cost index funds. That admission occurred in 1975, when he wrote a timeless article, titled The Loser’s Game. In the article, he explained the quandary that active managers face and quantified their disappointing results. It was the same year that Vanguard launched the first index mutual fund. In addition to writing and talking about the industry, Charlie serves on as an Investment Committee member of Rebalance IRA.

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Join the Index Fund Revolution!

When he entered the investment world fifty yeas ago, Charles (“Charley”) Ellis fund that diligent financial analysts and portfolio managers could routinely outperform the stock market. But as the investment industry changed, information became ubiquitous and institutions replaced individuals, it has become “unrealistic to try to beat today’s market.” I recently had the pleasure of talking to Charley about his amazing career and his new book “Index Revolution: Why Investors Should Join it Now”. The book and the conversation left me even more convinced that investors are spinning their wheels using anything but index funds to achieve their long-term financial planning goals and objectives.

It is quite stunning to hear this message from a man who began his life on Wall Street in the early 1960’s as an analyst and then as a financial industry consultant at Greenwich Associates, the firm that he founded in 1972. Perhaps because Charlie became a go-to resource for the biggest fund managers and Wall Street firms, his early view that most active portfolio managers could not keep up with the benchmarks they are trying to beat -- and that investors are better off in low-cost index funds – was so fascinating. That admission occurred in 1975, when Charley penned the now-prescient article “The Loser’s Game”. His view about the virtues of indexing has become stronger and clearer 40 years hence.

In his 18^th book, Charley is beating the drum for index funds. “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.” The most recent evidence from S&P Global proves the point: the S&P Indices Versus Active (Spiva) scorecard shows that 90.2 percent of actively managed US funds failed to beat their benchmarks, when their returns are calculated net of fees.

These types of reports have been available for years, yet index or passive funds still only account for a third of mutual fund assets. Sure, that’s up from a quarter three years ago, but a majority of individuals and professionals, some of whom owe fiduciary duties to their clients, “refuse to accept the objective data or insist on looking past it.”

Why do people delude themselves about beating the market, when as Nobel Laureate in Economics Daniel Kahneman, notes “They’re just not going to do it. It’s not going to happen.” Maybe investors want to believe that someone, some firm or some algorithm can beat the market, because the industry has told them that it is possible.

Early on, the asset management business condescendingly proclaimed that “indexing was for losers” and that investing in an index fund would be tantamount to confining your performance to just “average”. The industry’s marketing tactics has evolved, but even today, companies make big ad buys and trot out their analysts to tout “market-beating” funds, when the plain fact is that over time, they will not deliver consistent market-beating performance.

Charley notes that in making their case for active management, these folks rarely mention risk, nor do they adjust their data for taxes. Even the term “passive” can invoke a subliminal, negative connotation. After all, “Who wants to be passive?” asks Charlie. “Nobody will ever know just how much harm was done by wrapping the term passive around investing.”

Perhaps the most damning outcome of spending time and energy focusing your efforts on the fool’s errand of finding the market beating investments is that doing so can divert your attention from the more important financial planning issues in your life. Charlie writes that “Indexing simplifies everything,” and enables people to concentrate on “developing a balanced, objective understanding of themselves and their situation.” Amen.

Why You Stink at Investing

Did you panic when markets tumbled earlier this year? Do you feel better now that they have stabilized? If so, you aren’t alone. The hardest part of being an investor – even a long-term one – is coming to terms with a terrible truth: we stink at investing because we are human beings. In fact, the very cognitive behaviors that distinguish human beings from other forms of life, can lead us astray. I recently spent time with Dan Egan (check out Dan's appearance on my radio show), the Director of Behavioral Finance and Investments at Betterment, who explained that traditional economists believe that incentives, along with logical thought processes, will ultimately dominate our decisions. Behavioral economists “acknowledge that human beings are not always rational and want to help people make better decisions by using their emotions to their advantage.”

As an example, he cited retirement plan enrollment. Since the inception of defined contribution plans, traditional economists thought that the incentive of tax relief to retirement plan participants would be enough to encourage them to start saving money for the future. All they would have to do to enroll in a plan was to check a box. Easy, right?

But that’s not what happened. Many workers simply went along with the default option of not enrolling. To help boost participation, behavioral economists lobbied to change the default to be automatic enrollment and if workers wanted out of the plan, they would have to proactively check the box. Egan says that subtle change helped retirement plan participation soar “from about 20 percent of eligible employees to over 80 percent!”

Behavioral economists want to make it easier for us to do virtuous things, like saving for retirement and harder to do harmful things. Egan contends, “Doing the right thing should be effortless,” and even the small act of checking a box requires a bit of effort.

Another problem inherent with retirement saving is myopia, or our tendency to focus on the near-term, rather than the long term. When confronted with the choice of doing something fun today, like going on vacation with your family or using available funds to help secure a comfortable retirement decades in the future, guess which one tends to win out? Egan calls this the “tyranny of the here and now. To combat it, people need to identify with their future selves and to really think about what kind of life they hope to be leading years from now.”

When it comes to managing our money, being a human being can be downright dangerous. We suffer from two biases when markets are rising: overconfidence in our own abilities to pick winners and optimism, which convinces many investors that they can outperform the market.

Conversely, when markets are diving, we suffer from loss aversion (My dad used to refer to this as the investor line in the sand: “If my portfolio goes below X, I’m getting out!”), which can prompt us to withdraw capital at the worst possible time. When everyone else is selling, there is also a herding effect, when we do what everyone else does. And of course, many investors micromanage their portfolios, when according to Dan, “you will make more money the less you muck around with your accounts.”

All of these behaviors help explain why average stock investors lag the S&P 500 index by 1-3 percent annually and active traders often lag by more than 4 percent annually. Companies like Betterment are using behavioral science to help people overcome their very natures by automating the process of saving and investing. Maybe with a little prodding, we can improve our results.