How to be Above Average
“I own last year’s top-performing funds. Unfortunately, I bought them this year.” ~Anonymous
Welcome to RetireMentorship, Your Mentor To and Through Retirement. I am your host, Freeman Linde, Certified Financial Planner®.
Today we examine How to be Above Average. By definition, most people are average. By public opinion, most people think they are above average. This holds true with investing as it does with anything else. It is possible, however, to be above average. That’s coming up on the RetireMentorship Podcast.
First, the RetireMentorship Two-Min Tune-In. The primary points of the podcast in two minutes.
It is possible to get above-average returns in investing. I contend that most people don’t know what this means.
Many people think indexing means you get Average Returns.
Indexing is like achieving par in golf. It is possible to beat par, but most people don’t.
The Vast Majority of Investors and Professionals Underperform the Market.
They try and strike through trees, over water hazards, and into the wind. It only takes one 12 stroke hole to ruin your game.
People Who Have Outperformed in the Past are Unlikely to do so in the Future.
Just because you got par on three holes in a row doesn’t mean you will par the round.
It is Possible to Beat Par.
It starts will believing you cannot beat par. Then, adopting Pillars 6 and 7 while working Pillar 1, you can systematically do better.
Caveat! This episode is not merely a “Buy Index Funds and you’re good” message! And we are not giving investment advice. But it is a perspective worth seriously considering. Let’s dive in.
How to be Above Average
Most of us believe we are above average.
Let’s ask a question. Do you believe you are a good driver? Do you believe you are above average?
In repeated studies, 8 out of 10 men believe they are above-average drivers. This is clearly not possible. At least three of the eight are mistaken.
We regularly overestimate our abilities. We think fondly of our past successes and ignore or forget our past failures. We paint a picture of ourselves where we think we are at least slightly better than half of the population.
We do the same with investing. We know it is an integral part of our financial life. And we want to do well with it. We hope that we can do better than others. No one likes the idea of getting below-average investment returns. We seek the best.
In investing, there is the concept of the index. It is a collection of companies selected based on specific criteria, such as geography and size, not on past performance metrics. For example, the famous S&P 500 Index comprises Standard and Poor’s list of the 500 largest companies by capitalization. How that is calculated is irrelevant. Let the nerds figure that out.
There are mutual funds and exchange-traded funds that try to mirror the index. That is, they fund buys the stocks on the S&P’s list of 500 companies in the precise weighting that they are on the list. For example, as of February 16th, Vanguard’s S&P 500 Index ETF has Apple as its largest holding, at 6.7%, Microsoft next at 5.57%, and Amazon third at 4.34% of their total holdings. The same weightings as the S&P 500 list.
Vanguard doesn’t try and buy and sell companies based on what it thinks those companies will do. It simply buys the companies in the index in the appropriate weights. This practice is called passive investing. You can find index funds that track all kinds of indexes. All they do is buy companies on a list and sell them when they leave the list. Passive.
Passive? Isn’t passive bad? Shouldn’t we be proactive! Shouldn’t we do more than sit on our hands and let life happen to us?
Here is my first point.
Many People Think Indexing Means You Get Average Returns
The thinking goes that if these index funds are not trying to do anything other than match an index’s returns, minus a tiny fee, then applying any amount of skill should get you better returns than the market. Countless people try and beat those returns, both individuals and professionals.
If you look at any fund’s past performance, you will usually see it compared to what index it most closely resembles, even if it is not trying to track that index. The index will be known as the “benchmark,” and it is used as a reference point. And this is helpful because it allows you to see if the returns are due to the fund’s strategy or just due to general market movement. Sure, this fund averaged 7.8% over the last ten years. But the index averaged 8.1%. So that return wasn’t due to the fund, but due to the market in general.
There are thousands of investment professionals and fund managers and tens of thousands of DIY investors trying to beat these benchmarks. They see the indexes as “average,” and they are trying to beat them. They are trying to be above average.
I want you to think about investing as the “Investor Golf Tournament.” The tournament has two parts, the Working Half and the Retired Half. Each half is 36 holes, for a total of 72 holes, and each hole represents one year of investing. The wholes have different pars for each, but they all are between par three and par five. You have either three, four, or five shots to try to get the ball from the tee into the hole to be par.
In the Investor Golf Tournament, the indexes are par. Some people are better than par. Professional golfers and even serious recreational golfers beat par all the time. But par is by no means average. Even though all golfers are trying to make or beat par, most do not.
This quest to be above average by beating the indexes leads immediately to my next point:
The Vast Majority of Investors and Professionals Underperform the Market
Let’s look at each in turn.
We saw in Episode 1 that the Average Equity Investor had received about half the percentage returns of the investments the investor invests in. If you have not listened to Episode 1, you can find it at https://RetireMentorship.com/1. It is the essential episode for investing. Understanding the difference between investment and investor returns is critical.
Over 30 years, ending 2019, the S&P 500 averaged 10%. The average equity investor averaged 5%. Over that amount of time, the average equity investor would have turned $100,000 into $450,000. The S&P would have turned $100,000 into $2 million.
Again, that’s Average. Some investors did better; some did worse. But you cannot possibly say, based on that evidence, that the S&P 500 represents “average returns.” They are literally (and when I say literally, I am using it correctly) double the return of the average investor! The index is not average. It’s twice that of average.
That ongoing study by Dalbar applies to all investors, both those invested in professionally managed funds and those doing their own investing. Let’s look deeper and the DIYers.
There is a famous white-paper called “Trading is Hazardous to your Wealth.” The authors studied households trading their selected stocks to try and “beat the market.” Here is the abstract from the article.
“Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker [over a five-year period], those that traded most earned an annual return of 11.4 percent, while the market returned 17.9 percent. The average household earned an annual return of 16.4 percent… and turned over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.”
Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: https://ssrn.com/abstract=219228
The paper is a little dated now, but the truth holds today, as evidenced by Dalbar’s work and others. Investors trying to buy and sell their own stocks consistently underperform the market.
This effect disproportionately affects men over women in a negative way.
The authors did another study entitled “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” The abstract:
“Theoretical models of financial markets built on the assumption that some investors are overconfident yield one central prediction: overconfident investors will trade too much. We test this prediction by partitioning investors on the basis of a variable that provides a natural proxy for overconfidence–gender. Psychological research has established that men are more prone to overconfidence than women. Thus, models of investor overconfidence predict that men will trade more and perform worse than women.
“Using account data for over 35,000 households from a large discount brokerage firm, we analyze the common stock investments of men and women [over six years]. Consistent with the predictions of the overconfidence models, we document that men trade 45 percent more than women and earn annual risk-adjusted net returns that are 1.4 percent less than those earned by women. These differences are more pronounced between single men and single women; single men trade 67 percent more than single women and earn annual risk-adjusted net returns that are 2.3 percent less than those earned by single women.”
Barber, Brad M. and Odean, Terrance, Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment (November 1998). Available at SSRN: https://ssrn.com/abstract=139415
So not only will managing your own investments average you 36% lower returns than the so-called average index, single men are likely to receive 50% lower returns due to their own overconfidence. Bro, I hope you heard that.
Let me translate “overconfidence.” The belief that you are or can be better than others. The conclusions of these studies still ring true today.
That’s just the actual trading performance over five years. Then you throw in the behavior mistakes that we covered in Episode 4, the Four Horsemen, and you will get even lower returns over a more extended period.
When comparing the average investor to indexes over longer periods, the index is decidedly not average.
So what about professionals? Most investors don’t buy and sell individual stocks anyway. They entrust that to mutual fund managers in their 401(k)s and their investment advisors in their IRAs. Surely those professionals with their skills and expertise can beat these “average indexes.”
Professionals do perform better than the average individual stock trader. But most of them do not beat the indexes after fees. Many studies support this phenomenon.
Only 30-40% of active managers beat the index in any given year. According to Barrons, only 29% of Active Managers beat their benchmark in 2019, down from 37% in 2018. Of the active managers who did beat their benchmark in 2018, only 12% beat their benchmark in 2019.
CNBC reported that 92% of professional investment managers underperform their relevant indexes over 15 year periods.
Your immediate thought on hearing this may be, “Yes, but 8% of managers did beat the indexes over 15 years.”
Or, in the immortal words of Loyd Christmas, “So you’re telling me there’s a chance.”
The Index Fund Advisor reported the following. “The S&P 500 Index consistently outperformed 98% of mutual fund managers over the past three years and 97% over the past ten years, ending October 2004. In two 30-year studies, the S&P 500 outperformed 97% and 94% of managers. In addition, only about 12% of the top 100 managers repeat their performance in the following years. Therefore, it is not possible to consistently pick next year’s hot mutual fund manager.”
As Bethany McClean of Fortune put it, “Building a portfolio around index funds isn’t settling for the average. It’s just refusing to believe in magic.”
To summarize, I’m not saying it’s impossible to beat indexes. I am saying that most people don’t, just as most people don’t beat par in golf.
You may shoot par or better on a hole or two. But as any golfer knows, a few bogies will soon throw off your entire game.
Let’s reinforce this with the third point:
People who have Outperformed in the Past are Unlikely to do so in the Future
Again, 12% of professionals who do outperform the index in a particular year underperform the following year.
Most people can see that outperforming in one particular year does not mean that you will go on to outperform every year or even most years. If you get a birdie on a golf hole (one under par), this does not mean you will go on to birdie every hole, or even that you will ever birdie again! What is more, one bogie will erase that birdie. You don’t win a golf tournament by getting one birdie. And you don’t get superior lifetime returns by outperforming one year.
But there is a popular myth out there that people have developed to combat this one-year-performance issue. The myth goes like this:
If you want to have above-average returns:
- Compare the long-term track record of funds and then pick the funds with the best long-term track record.
- Ignore the 1- or 3-year returns.
- Look at the 5- or 10-year returns or the since-inception returns (returns from the day the company started the fund).
- By selecting the funds with superior 10-year or since-inception track records, you will likely continue to see superior future performance.
Two things right away.
- Never compare funds based on their since-inception returns. Since the funds start at different times, their returns will be wildly different. A fund that started in March of 2009 (the bottom of the financial crisis) and has gone nowhere but up will have a way better since inception return than a fund started in September of 2007 (the previous peak). Their performance since 2009 might be identical, but their since-inception returns will be worlds apart.
- 5- and 10-year returns are not “long-term.” Certainly not five years. And I want to challenge you on ten years. The average investor will be working and investing for 40 years and will be retired and investing for 30 more. When you are thinking about long-term returns, you should be thinking decades, not years.
Beyond that, long-term returns might not be due to continued discipline and strategy. It may be just due to luck.
Suppose you are chatting with a fellow golfer in the Investor Golf Tournament, and he reveals that he is four under par after ten holes. You think at first, “Wow, this is a good golfer. He must be consistently getting pars and birdies. At this rate, after 72 holes, he is going to be 28 under.”
But then you find out two things.
- In his first hole, a par 5, his drive was hard and far. But he sliced it, shooting off to the right and missing the fairway. The ball bounced off a cart path and hit a groundskeeper’s mower that blasted it back toward the hole. It bounced off a tree and dibbled straight into the hole—a hole-in-one on a par five. Thus, the four under. He’s been hitting par ever since.
- He retried his drive from the tee-box ten times! He kept taking mulligans for his bad drives until he hit the lucky shot. That was the one he decided to play.
Now how do you feel about him? He certainly isn’t the world-class golfer you thought he was. He’s gotten several pars, yes. But his edge was by luck and cheating.
This is how many mutual funds operate.
You can compare the “long-term” ten-year track records of funds, and you can see that one fund has a better ten-year average than the other. This observation may lead you to believe that the first fund has been consistently outperforming the other, leading to the gap in returns. But this may not be true.
When mutual fund companies create mutual funds, they often create several at the same time. Perhaps they start ten new funds with slightly different strategies. They each buy slightly different combinations of companies. They are all private at first, not on the general market. Five of the funds outperform the indexes, and five of the funds underperform. They close the funds that underperformed and release the remaining five to the public.
In the first year, one of the five seriously outperforms, and the other four underperform. No one wants to invest in a new fund already underperforming, so they close the four and keep the one. Going forward, that last fund of the original ten only needs to make “average” returns by generally tracking the index. But because it got lucky in the first year, it will now have a five-year, ten-year, and since inception track record of being better than the index. And they can charge higher fees for that initial luck.
It happens all the time. A fund’s outperformance isn’t due to superior strategy or disciplines. It may only be superior because of luck. The company “took a mulligan” on the other nine funds it developed and kept the one that had the good fortune to buy Amazon before it took off.
Investment advisors are no better. Thankfully, most good financial planners and investment advisors don’t try to compete on performance. But some still do. Their so-called “outperformance” may be due to the same phenomenon as the mutual fund manager. They made one good call, and they have been riding it ever since.
There used to be a practice with stockbrokers many moons ago, which I’m pretty sure has been made illegal, and I don’t think anyone does it now. A stockbroker would call 128 random people after the market closed and leave a message if no one answered.
“Hello, I am Stock Broker with XYZ Firm. I know you have reason to trust me or invest with me yet, but I’m going to prove to you that I can predict the market and get you above-average returns. I predict that tomorrow the market will go up. I’ll call you back tomorrow and predict the next day. Have a great day.”
Half the calls he would predict the market would go up—half the calls he would predict that it would go down. The next day the market would do one or the other (as it always does). If the market was up at close, the broker would call only the 64 people he predicted it would go up and forget about the other 64.
“Hello, I am Stock Broker with XYZ Brokerage. As I predicted, the stock market went up. But you might be thinking, ‘Big whoop. Anyone can be right once.’ To prove that I’m the real deal, I’m going to predict again. Tomorrow, it will go down. I’ll call you tomorrow. Have a great day.”
Half the calls he would predict the market would go down, the other half that it would go up. The next day, the market would go up or down (as it always does). He’d call the 32 investors that he predicted correctly and forget about the others. They’d probably forget about him, too.
You see where this was going. After five days, he would be down to 4 investors, cutting 128 in half five times by pure luck.
“Hello, I am Stock Broker with XYZ Brokerage. I’ve predicted the stock market five days in a row now, and I have been right every time. Are you ready to invest with me?”
He demonstrated superior returns… purely from luck and the game of numbers.
To my knowledge, no one does this anymore. But I contend that those who point back at their track record and point to it being superior because of their insights and expertise alone are also misguided and may be misleading.
You run into that golfer again on hole twelve. You find out that he is no longer four below par. He is now five over. Because he is in the middle of the tournament, he can no longer get away with mulligans. His first drive went into the water hazard. He sliced his second out of bounds. His third was playable but not on the fairway. He tried to split two trees and hit one of them, bouncing the ball back further away. Anyone who has ever golfed has experienced this scenario. You are playing well the entire round, and then you have that hole where everything goes wrong, and you get it in nine strokes—track record: ruined.
Those who have previously outperformed, both in golf and investing, are not guaranteed to outperform in the future.
There is no evidence for the persistence of performance.
I am not saying there is no way to identify winning strategies that will beat par or an index in the future. I am simply saying that you cannot identify that strategy from past performance.
This conclusion is why, in Episode 5 – Five Questions to Ask Your Financial Advisor, I said that asking about past performance is a dumb question. Past performance is no guarantee of future results.
Many people believe that an index represents average returns. In fact, indexes double the average investor’s returns over thirty years and outperform 92-98% of all professionals over long periods. And the few who have outperformed in the past are unlikely to do so in the future.
What shall we say then? Just buy the S&P 500 Index fund and do nothing else?
In theory, this would mean you would double the average investor’s returns over thirty years and be seriously above average. However, this assumes that you never fall to chasing returns, poor diversification, euphoria, or panic… over three to six decades. Evidence shows that most people cannot do this. Not without pillars one and two from last week, built on pillars three through five.
I reject the common thought that everyone should merely buy an index fund because of its low fees and good performance. It ignores behavior, which makes up the majority of a person’s lifetime returns. And I’ve encountered people who, in their quest for low fees, have chosen index funds with truly terrible long-term returns. There is more to it than merely “going passive.” You need the Seven Pillars that we covered last week.
If you have all seven pillars and practice them faithfully, you will be above average. Let’s examine the last point.
It is Possible to Beat Par
I’m not a good golfer. I perform pretty poorly on the first nine holes (par 36) and usually worse on holes ten through eighteen (par 72 total). Someone in my office is a good golfer, and he heard that I was going golfing over a weekend. On Monday, he asked, “So you went golfing? How’d you do.”
I said, “You know, pretty good. I got a score of 80.”
“Eighty!” he exclaims. “That’s really good!”
“Well, yes,” I admit. “But I only golfed nine holes.”
That’s the kind of golfer I am.
In investing and golf, you are not directly competing again anyone, but you can see how you line up against everyone. So let’s suppose that I need to play in this Investor Golf Tournament. My whole financial life is depending on my performance in this tournament. Luckily, I don’t have to win; I need to play reasonably well across 72 holes, par 288. I need to try and get under 300 strokes and no worse than 400 strokes.
That’s a lot of golf. Again, my lousy performance gets worse after just nine holes. Whoopie. Only 61 more to go.
If the stakes were that high, that my family’s whole financial future depended on my personal performance in this epic tournament, I’d probably find a coach.
Suppose I was approached by a coach who proposed the following.
“I can teach you how to make par. I can tell you this for sure: my strategy takes enormous discipline and patience. And I can promise you that you will never get an eagle on any holes, never get two under par. And we can be reasonably certain you will probably not get any birdies either, although you might. What I can tell you is that, using my plan, working with my coaching, and applying discipline and patience, you will get at least par on every hole.”
I’d hire that coach.
I wouldn’t care about getting birdies and eagles. I wouldn’t care about getting the longest drive or making the put that was furthest from the hole. To ensure that my family’s financial future would be set, I only need to get less than 300 strokes. I don’t care about how many strokes I am over or under at hole 10, 30, or 50. It only matters what my score is on hole 72. And if I can be assured that I would get par on every hole, that would result in a score of 288, less than the 300 I need. Even if it meant never getting any eagles and likely never getting any birdies, I would take that deal in a heartbeat.
If you’ve ever golfed and know how bad you are, I’m sure you’d take that deal too.
Here’s a problem. We have celebrity investors out there that do consistently beat the S&P 500 or other indexes. We hear things like, “You should invest like Warren Buffet,” or, “This is how fund manager Peter Lynch beat the market for decades, and how you can too!”
But I’m not Warren Buffet or Peter Lynch, any more than I am Tiger Woods or Rory McIlroy. Those golfers would probably not take a “guaranteed par” deal. They can beat par over 72 holes, by a lot. Par doesn’t interest them; birdies and eagles do. But I’m not them. And neither are you.
So invest on principles and disciplines, yes, but realize that just because some billionaire buys a bunch of bitcoin doesn’t mean you should.
We set out to answer “How to be Above Average.” Here it is.
If you want to be above average, this means beating the average investor. To do that, you need to do two things:
- Adopt and practice, for 3-6 decades, the Seven Pillars of Victory.
- Avoid and destroy, for 3-6 decades, the Four Horsemen.
If you want to beat par, as opposed to beating average, you must first recognize that those are different things. Beating par is somewhat trickier but still possible. You need three things to beat par:
1. Never fall too far behind.
If you score a ten or eleven on a par four at any point in a golf tournament, it is pretty hard to come back from that. Again, no one should care what your score is on hole ten, as long as it isn’t too far behind. It only matters what it is on hole 72. But coming back from eight over is tough. It is also tough coming back from a huge loss that was only suffered by you and not the index or missing out on a huge gain that the index did get.
2. Don’t own any categories that have always underperformed.
I’m not saying you shouldn’t own a fund that has underperformed the S&P 500 over the last three years. I’m saying don’t own any asset classes that have always underperformed. Your total portfolio won’t outperform the S&P 500, won’t beat par over 30 to 60 years, if 10-40% of it is in bonds. Not possible. Even if your equities outperform, your portfolio won’t. It doesn’t help to get excellent scores on all par-three and par-five holes if you bogie every par-four hole. It doesn’t matter if half your portfolio is slightly overperforming if the other half is performing half as well.
3. Invest in multiple equity categories that have historically outperformed at times.
Not funds that have outperformed the S&P 500 always (you can’t find those), categories of equities that have outperformed at times. It is doubtful you will beat the S&P 500 by owning a fund that actively trades in the same 500 companies. You must add in funds that are in other categories spread across large, medium, and small caps, value and growth, and the like. Owning these must all be part of a plan with a partner that you understand, believe, and act on with patience and discipline.
These statements are not investment advice. I’m not telling you to do this, nor am I’m saying you should. But you asked how to beat par, and this is how you would go about trying—creating a plan involving 100% equities spread across multiple categories perfectly worked with all seven pillars for 30 to 60 years.
Simple. Not easy.
If it’s intriguing to you, find yourself an advisor or planner who understands this and can help you build and follow such a plan.
The averages say you won’t do so otherwise.
You can beat the average. It’s even possible to beat par. First, you must understand that those are as different as investor returns and investment returns.
If you have questions about this topic or any other topic, you can send an email to Questions@RetireMentorship.com. Or you can call us at 1-855-6-MENTOR (663-6867) and leave a voicemail. We will respond to you directly, and if we get the same question repeatedly, we’ll turn it into an episode.
Next week we are giving our answer to the question, “Is Dave Ramsey Wrong?!” Subscribe to get that when it comes out. The week after, “Breaking News! Journalism Ain’t your Friend.” We’ll explore how consuming the news, especially financial news, is destining you for below-average lifetime returns and potential financial ruin.
Thanks for listening, and we will see you next week.
This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.