When you read up on investing, it’s easy to get the sense that there’s one way to invest for “average” people, and another way to invest if you really know what you’re doing.
You know what I’m talking about. You’ll hear people say things like, “Index investing is great for the average investor,” or, “If you’re new to investing, index funds are the way to go.”
Statements like that aren’t incorrect, but they carry a subtle implication that there’s something better out there. That index investing is “fine,” but that there’s a way to get better returns if you’re willing to work a little harder.
It’s not true. There isn’t something better out there, and believing that there is will almost certainly make it harder for you to reach your financial goals.
When it comes to investing, the “average” approach is actually much better than average. Here’s why.
‘Average’ Is Not Always What It Seems
I always get a kick out of people who claim that index investing is good for the “average” investor, or that it’s a good way to get “average” returns.
In a sense, those people are correct. Index funds are designed to mimic the return of an entire market, and in that sense they do provide average returns. A U.S. stock market index fund provides the average return across all U.S. stocks.
But the idea that those returns are “average” in comparison to what other investors reap is, quite frankly, ridiculous.
Here are some interesting findings that academic research has unearthed over the years:
- Most actively managed mutual funds underperform their benchmarks over both short and long time periods.
- The active funds that do manage to outperform over one time period are less likely than chance to outperform again over the next time period. (In other words, the good funds don’t stay good.)
- Investment portfolios made up of index funds outperform portfolios made up of active funds 80% to 90% of the time.
- Individual investors typically underperform the funds they invest in, often by several percentage points per year, due primarily to their attempts to get better returns.
It’s gotten to the point where the only real argument left for active investors is that someday index investing might become so popular that active investing becomes a reasonable alternative. And not only is that unlikely, it’s a hypothetical argument about the future, not an argument that active investing will lead to better results right now.
What will lead to better returns right now, according to all the best research we have to date, is investing in a portfolio of index funds and sticking with it for the long term. That approach is likely to give you better results than 80% to 90% of other investors.
How’s that for “average”?
I’d Rather Be ‘Average’ Than Broke
American culture pushes us to be the very best we can be. We’re taught that we can do anything if we work hard enough, and that we should never settle for anything less than our dreams.
Sometimes this is a fantastic mindset. It’s part of what makes this country great in so many ways.
But it can also be used against us. Financial companies prey on this mindset to make us feel like index investing is for “lesser investors” and that we can do better if we trust (and pay for) their expertise. If you believe in the American dream, that you can do anything you put your mind to, you can certainly do better than accepting the “average” return of the stock market.
But it’s a lie, and it’s one that can rob you of your financial future. Not only will active investing likely lead to lower returns, but you’ll almost certainly pay a hefty fee to get them. It’s a double loss that makes it harder for you to reach your financial goals.
I don’t know about you, but if being average means outperforming 80% to 90% of other investors, I’ll happily swallow my pride and accept my middling mediocrity.
- What Is Index Investing, and Why Does It Work?
- Why Don’t Professional Investors ‘Beat the Market’?
- Eight Investing Fees to Watch Out For
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.