Average Investment Returns are Great!

In our society, being “average” gets a bum rap. How many parents admonish their children to “be average” as they send them off to school? How many students brag about their “straight C” report cards? How many employees argue they deserve a big raise to reward their middling job performance?

Due to our belittling of being average, few investors strive to earn investment returns that are merely average. Instead, we try to be “smart” investors by buying the next Google or Apple, or by timing our stock purchases to “buy low and sell high”. Unfortunately for “smart” investors, it turns out their investment results are routinely crushed by “average” investors.

The lesson? We should strive for average stock market returns.

“Smart” investors have theories about why one company’s stock will soar while another company’s stock will crash, or why one sector of the economy will flourish over the next year while another sector flops, or why one mutual fund manager is smart enough to beat the market by ten percentage points while another manager has lost his way. They act on their theories by rapidly buying and selling stock.

“Average” investors have basically thrown in the towel with respect to trying to predict which company will do better than another company, or which sector of the economy will outperform another sector, or which mutual fund manager will have a good year. Since they admit their ignorance, they act by buying a low-cost mutual fund or exchange-traded fund that tracks an index, such as the S&P 500 index.

“Smart” investors may be more interesting than “average” investors at cocktail parties. After all, it’s more interesting to talk about the next Microsoft or Google or Apple. But who’s the better investor?

For the 20-year period from January 1, 1990 to December 31, 2010, the average annual return of the S&P 500 Index was 9.14%. However, the typical equity investor earned a return of only 3.83% during this period. In other words, the typical investor earned only 42% of the average stock market return!

Converting this investing shortfall into dollars is even more sobering. Assume your “smart” neighbor started with $10,000 to invest on January 1, 1990. Based on his theories about companies, economic sectors and mutual fund managers likely to beat the overall market, he grew his initial investment to $21,485 by December 31, 2010 ($10,000 at 3.83% for 20 years). He brags about doubling his money.

Now, assume you were an “average” investor who also had $10,000 to invest on January 1, 1990, but you simply bought a low-cost mutual fund or ETF that tracked the S&P 500. You grew your initial investment to $61,785 by December 31, 2010 ($10,000 at 9.14% for 20 years)! By throwing in the towel, you ended up beating your “smart” neighbor by more than $40,000 on your initial $10,000 investment!

Why were you the better investor, even though you were “average” and your neighbor was “smart”?

The most important reason why “average” investors routinely beat “smart” investors is psychology. “Smart” investors tend to pour money into the market when they feel confident because equities are going up, and then pull money out of the market when they feel fear because equities are going down. As a result, they buy high and sell low—just the opposite of their goal of buying low and selling high. In contrast, “average” investors leave their money invested throughout market cycles, and end up buying low and selling high since the stock market has a tendency to increase over long time periods.

There are other reasons why “average” investors routinely beat “smart” investors. By frequently trading stocks, “smart” investors incur high transaction costs due to commissions on each buy and sell order. By investing in actively-managed mutual funds, “smart” investors incur higher fees. By quickly realizing investment gains as they churn stocks, “smart” investors have higher tax obligations. “Smart” investors may also spend more preparing their tax returns due to higher complexity.

Most investors will enjoy higher returns once they stop trying to beat the market, but simply invest in low-cost mutual funds or ETFs that track an index, such as the S&P 500 Index. This is because, oddly enough, the average return of the stock market soundly beats the return obtained by typical investors. Long-term investing is one situation where trying to be “average” is better than trying to be “smart”.