24. Average is Good

Hard to be average, isn't it? When I used to date, the term "average" meant "below-average" (when it comes to character and personality) or "above-average" (when it comes to weight). It was never a good thing. Who wants to be average?

Yet, when it comes to investment philosophy, there are two important realization you should make:

1. Average is good enough.
2. Average is as good as you can have anyway.

The first insight comes from looking backward at the world economy and seeing the constant trend of growth, and how it's reflected in the stock market. Yes, there are setbacks: wars come and go, bubbles inflate and diminish as investors switch from irrational exuberance to gloom and doom every few years. At the same time, technology waves obliterate value and entire companies (Block Buster, Novell) while creating value in other areas (Netflix, Apple). But still, the overall picture is of growth - we make more, we produce more, we consume more, we create more, and our enterprises are worth more. This is why investing in the world economy has produced returns that are significantly above inflation for the last 100 years. If you ride this wave, you have excellent chances of achieving high returns. The numbers vary - some quote 8-10% average returns, or 5-6% net of inflation. These numbers assume very long term investing. Still, even people in their 40s and 50s should assume they can be invested for at least 30-40 years - there's no rule saying you need to convert everything you have to cash when you turn 65. Assuming a long investment horizon, you definitely want to ride this wave.

The second insight is that the market is so complex and so efficient that fighting it is futile. On average, all players in the market get, hmmm, average returns. This is the meaning of the term average, right? For every "winner" mutual fund (or a managed account professional), who beats the average, there must be a "loser", who gets below-average returns. You can't fight arithmetic. You can of course gamble - pick up a mutual fund at random, and you do have about 30% chance of beating the average (and 70% chance of ending up worse than the average). These are incredibly bad chances. Even casinos give you a 48% chance of beating them. The financial industry has gotten away with it for many years, but there's no way you should play their game.

There are many reasons for the below-average returns of mutual funds: excessive management fees, high turnover ratio, transaction costs and loads and tax inefficiency. We've covered all of that in previous blogs. But the main point is that the mutual funds and the account managers are fighting the windmills of the world economies and a market that is by and large efficient enough to force them into average returns.

By using a mutual fund or a portfolio manager you'll be signing up for diminished returns a priori, donating a fixed percentage of their account every year to the financial industry.

Bill Barker, writing for the Motley Fool, writes: "The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. For that reason, investors who are going to invest in mutual funds rather than in individual stocks should hold a very, very, very strong bias toward investing in index funds, which invest across the board in a stock market index." John Bogle in The little book of Common Sense Investing includes a graph of the number of mutual funds that have failed, on a year-by-year basis, to match the returns of the S&P 500. The results are staggering:

For once in my life, I feel that average is good.