The following question was asked on Quora
If 98% of funds don’t beat the market, why do people still give their money to financial advisors and money managers? Why doesn’t everyone just invest in a low cost index fund that follows the S&P 500?
Here is my response:
This answer is in 3 parts so I can cover it from different perspectives.
Answer Part 1: 80–20 rule works in investing too – this is not an indictment of the system.
The 98% number is false. It is more like 70–80% of the funds lose to the market, depending on the time period and asset class under consideration.
The latest S&P research on this is here. They have data going back many years, but I will briefly summarize the 2018 year data
- 68.83% of the domestic equity funds lagged S&P1500
- 64.49% of the large cap funds underperformed the S&P500
- 68.45% of small cap funds underperformed the S&P 600
- 54% of the large cap value managers beat the S&P 500 value index
- 84.80% of the mid cap growth funds beat the S&P 400 midcap growth index
- Over the long investment horizon, such as 10 or 15 years, 80% or more of active managers across all categories underperformed their respective benchmarks
Other way to see this is, 20-30% of the funds beat the index over the long term.
In any field of human endeavor, excellence is achieved by a very small segment of the population. The term 1% was very popular a few years ago. The 80–20 rule is now popularly accepted as an indicator of the how the world works – 80% of the results accrue to 20% of the activities.
In almost all cases, people strive for excellence. They work hard to be in the top 20% (or even top 1%).
Perhaps investing is the only field I know where the conventional advice is to settle for mediocrity.
This is the only way non-performing funds can sell themselves to the investors.
Answer Part 2: Index funds do command significant portion of the investment dollars
Unfortunately, a large portion of the capital in the market is now allocated to index funds. Bank of America Merrill Lynch estimates the number to be 45%. This is up from 25% about a decade ago.
So much so that it is now a significant risk to the integrity of the stock market itself.
Answer Part 3: Investors underperform the funds they invest in
Dalbar conducts annual study of investor returns. They have consistently found that the investors perform worse than the funds that they are invested in. The main reason being that retail investors tend to add or remove monies to the fund at the wrong times. Index funds do not make you immune to your lack of discipline in investing.
While the argument that most funds underperform the market is correct, the implication that as a result investors should just buy index funds is wrong.
If you are like most investors, buying index funds will see you severely underperforming the market.
You are better off in an active investment with a manager with good track record of disciplined investing.
On the other hand, if you are a disciplined investor yourself, you can do better than an index fund on your own.
And what better way to invest then follow the advice of the Oracle of Omaha himself. If you are interested, I have collected 9 of the most important investment advice Warren Buffett has given out, over his long career.
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