The Stupidest Thing You Can Do With Your Money

I recently encountered one of the best podcasts that I’ve ever heard on the subject of investing.   In a re-broadcast from Freakanomics Radio, Stephen J. Dubner takes a look at a phenomena that I’ve wondered about for a long time.    In The Stupidest Thing You Can Do With Your Money he essentially asks the question, “why are so many people willing to pay for subpar performance?”

The assertion of the episode is that active management remains the preferred choice for most investors despite chronic under-performance.  There are about 60 years of research and data to support the idea that after subtracting fees - active management is very unlikely to generate value to the investor.   This well-produced show tells a fascinating story through interviews with Jack Bogle (the founder of Vanguard), Kenneth French (renowned finance professor), and Eugene Fama (Nobel Prize winner).  

Some other industry insiders are also represented to give opposing views, but there really isn’t much debate among professionals and academics.  The facts are hard to argue against.  In fact, it’s difficult to find anyone in the investment community that even tries to refute the premise that the great majority of active investors under-perform when compared to low-cost passive strategies.   Even Warren Buffet, arguably the single greatest investor of all time, advocates for index funds.  I’ve addressed this topic many times over the years, most recently in A Sucker’s Bet, which highlights how a passive index fund has clobbered the best hedge fund managers in a head-to-head competition over the last ten years.   Why then, do people continue to turn over their hard earned money to investment managers? 

Awareness of index funds is certainly increasing.  Money has been pouring into Vanguard funds in recent years at an astonishing pace, making it the largest investment company in the world.   The podcast describes this as a revolution, which I suppose it is, but it’s a “quiet” revolution.   Target date retirement funds are often the default choice for 401(k) participants and some are comprised of index funds.    To their credit, some large employers, like Ford and GM, have arranged access to very low-cost investments within employee retirement plans for those knowledgeable enough to sift through an array of choices.   Institutional money has to a great extent taken advantage of the abundance of research and data available, and some smart retail investors have also found their way to index funds, but there is not yet general understanding of the superiority of index strategies over active management.    To gain broader acceptance, I think more education is needed.

The Freakinomics podcast attempts to explain the logic behind low-cost investing.  Investing is a zero sum game before costs – because for every trade there is a buyer and a seller.  Investing is a negative sum game after costs, because both the winners and losers pay the fees.   The efficient market hypothesis, which is generally advocated by Bogle, Fama, and French, and which is one of the underpinnings of index funds, doesn’t mean that markets are perfectly efficient.  It just means that markets reflect all known information.   So, it is difficult for anyone to gain an advantage.  When all is said and done, very few investors can overcome the drag of expenses to take advantage of any inefficiencies to earn a higher return than a low-cost, buy and hold strategy.   Fama has found that only 2% or 3% of all investors had enough skill to overcome their costs.   These are bad odds for an investor looking to professionals for help.

Of the few investors who might seem to beat the market, it’s mostly by chance.    How do you identify the few extraordinary managers in advance?   Using past performance to select the best mutual funds or money managers is a futile exercise because the top performers are unlikely to remain in the top tier going forward.     As explained by Bogle, the end result is that investors put up 100% of the capital, take 100% of the risk, and get a fraction of the return!

Bogle goes on to ask, why did it take so long for index funds to become popular?  I wonder, why are they not more popular?  Clearly, the Wall Street marketing machine is one major reason.  The active money management industry has considerable resources to fight this revolution and they are highly motivated, because index funds are truly their “worst nightmare”.  

Sadly, there is much more to overcome than just industry opposition.   Human beings can be very irrational creatures.  There are numerous mind traps that make investors their own worst enemy.   One must delve deeply into the emerging discipline of behavioral finance to understand why smart people do stupid things with their money.   I hope to explore this mystery in future articles.   For now, I will do my part to advance the revolution by inviting you to listen to this excellent podcast The Stupidest Thing You Can Do With Your Money.