Indexing: When being 'average' is a lot better than average

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arcticpineapplecorp.
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Indexing: When being 'average' is a lot better than average

Post by arcticpineapplecorp. » Fri Dec 16, 2016 9:46 am

Saw this article today and thought it be good for new folks to understand that "getting the average return for the market" does in no way mean "being average".
Not only did Vanguard founder John C. Bogle launch the first index mutual fund in 1976, but he also was among the first to clearly explain to the investing public the benefits of what was then a novel, unproven strategy.

In 1977, in the first annual report for what was later renamed Vanguard 500 Index Fund, he wrote that an index fund "represents a tough and demanding 'par.' . . . And if there are some professionals who can 'beat par' more often than not—in investing or in golf—they do not seem to be in the majority'...

The data speak for themselves
The track record looks even more discouraging for active funds when you consider that of the 35% of them that outperformed the index, only 119—or about 10% in all—did so by more than 1 percentage point. The 315 others also took on risk to try to outperform the index (and likely experienced greater volatility) but surpassed it by less than 1 percentage point in average annual return.

Indexing may have been a hard sell 40 years ago, but it has won over many investors in the decades since. Its share of U.S.-based exchange-traded fund and mutual fund assets stands at a little more than one-third, representing about $3.5 trillion.
https://personal.vanguard.com/us/insigh ... =Position1

Enjoy!
"May you live as long as you want and never want as long as you live" -- Irish Blessing | "Invest we must" -- Jack Bogle

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David Jay
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Re: Indexing: When being 'average' is a lot better than average

Post by David Jay » Fri Dec 16, 2016 10:03 am

"Par" is a great metaphor. The vast majority of folks out on the courses would love to be scratch golfers.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Abe
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Re: Indexing: When being 'average' is a lot better than average

Post by Abe » Fri Dec 16, 2016 11:28 am

I know absolutely nothing about golf, but when I look up the definition of par, it says:
Par: An amount or a level considered to be average
So, by definition par is in the mid range. When I think of a football player or a basketball player as being average, I think not too good, not too bad, you know, just average. Apparently if a golf player plays par, or average, he is actually playing better than average. I'm confused. :confused
Slow and steady wins the race.

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PaddyMac
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Re: Indexing: When being 'average' is a lot better than average

Post by PaddyMac » Fri Dec 16, 2016 11:35 am

Abe wrote:I know absolutely nothing about golf, but when I look up the definition of par, it says:
Par: An amount or a level considered to be average
So, by definition par is in the mid range. When I think of a football player or a basketball player as being average, I think not too good, not too bad, you know, just average. Apparently if a golf player plays par, or average, he is actually playing better than average. I'm confused. :confused
As a one-time golfer, it's easier to think of "par" as the number of shots that you would take if you played the hole in a really solid way (not amazingly well, not lucky, not unlucky). So if it's a par-3, you would hit one good shot to land somewhere on the green, hit a good putt to within a foot, and then tap it in. If it's a par-4 (longer hole), you would hit one drive somewhere down the fairway, hit the second shot somewhere on the green (or close to it), and then two shots to get in the hole.

Needless to say, most golfers cannot play to the par number CONSISTENTLY on all 18 holes. They might play a nice par 3, maybe even play 3 shots on a par 4 now and then (for a "birdie), but then they have a 7 on the next par 4 because they messed up and hit the ball out of bounds (2-shot penalty). So overall, the numbers won't add up to a par round.

So yes, that's a good analogy for active funds vs. index funds (a solid par on every hole regardless).

MI_bogle
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Re: Indexing: When being 'average' is a lot better than average

Post by MI_bogle » Fri Dec 16, 2016 11:42 am

Abe wrote:I know absolutely nothing about golf, but when I look up the definition of par, it says:
Par: An amount or a level considered to be average
So, by definition par is in the mid range. When I think of a football player or a basketball player as being average, I think not too good, not too bad, you know, just average. Apparently if a golf player plays par, or average, he is actually playing better than average. I'm confused. :confused
There are layers to the definition, which is why you are confused.
In golf, par is the predetermined number of strokes that a scratch (or 0 handicap) golfer should require to complete a hole, a round (the sum of the pars of the played holes), or a tournament (the sum of the pars of each round).
Ahh! So we need to also define "scratch golfer" to make the definition make sense!
A "scratch golfer" is a player who can play to a Course Handicap of zero on any and all rated golf courses. A male scratch golfer, for rating purposes, can hit tee shots an average of 250 yards and can reach a 470-yard hole in two shots at sea level. A female scratch golfer, for rating purposes, can hit tee shots an average of 210 yards and can reach a 400-yard hole in two shots at sea level.
Most people are not "scratch golfers". Par refers to the average scratch golfer, not the average golfer.

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Abe
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Re: Indexing: When being 'average' is a lot better than average

Post by Abe » Fri Dec 16, 2016 1:38 pm

MI_bogle wrote: Most people are not "scratch golfers". Par refers to the average scratch golfer, not the average golfer.
So a par player is the average expert player, not the average average player. :happy
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Re: Indexing: When being 'average' is a lot better than average

Post by corysold » Fri Dec 16, 2016 1:42 pm

To keep the golf analogy going, if you could shoot "par" on every golf hole you ever played, you'd be one of the best 170 golfers in the entire world.

There would be some better than you (Tiger Woods = successful hedge fund), but you'd outperform nearly every other golfer in the world.

Par is what golfers aspire to shoot, but very few actually reach their goals.

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Kenkat
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Re: Indexing: When being 'average' is a lot better than average

Post by Kenkat » Fri Dec 16, 2016 1:48 pm

Indexing and active management return the same "average" before expenses (ER and turnover). After you factor in the (typically) much greater than average expenses of active management, the curve shifts in favor of indexing. Combine this with the fact that active management success tends to not persist (i.e., over time, superstar managers will falter), it is too much for the typical active fund to overcome.

In other words, indexing is only "average" before expenses; it is above average after.

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Re: Indexing: When being 'average' is a lot better than average

Post by arcticpineapplecorp. » Fri Dec 16, 2016 1:55 pm

Abe wrote:So a par player is the average expert player, not the average average player. :happy
I like that definition because when you wrote:
When I think of a football player or a basketball player as being average, I think not too good, not too bad, you know, just average
the first thought I had was, "Well an average NBA star is still better than the average (of ALL) basketball players in the world (professional or amateur, etc)".

So by that metaphor, indexers are the average expert players (not average average players). Though I hate the metaphor of investing as a "game" and I hate when people ask if I "play" the market. :annoyed
Last edited by arcticpineapplecorp. on Fri Dec 16, 2016 2:07 pm, edited 1 time in total.
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David Jay
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Re: Indexing: When being 'average' is a lot better than average

Post by David Jay » Fri Dec 16, 2016 2:00 pm

arcticpineapplecorp. wrote:So by that metaphor, indexers are the average expert players (not average average players).
This metaphor continues to work as I spend more time thinking. Par is the performance of all of the wizards of Wall Street. They are the "pro" players in the financial game.

And I can match their performance (beat it after expenses) with a simple index fund! :happy
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: Indexing: When being 'average' is a lot better than average

Post by MarkNYC » Fri Dec 16, 2016 2:42 pm

As a low-cost index investor, here is how I view accepting "average returns" each year, using estimated percentages: The annual returns are only average before expenses (expense ratio and portfolio transactions costs). The annual returns are slightly above average after expenses, putting me ahead of 55% of all active investors the first year. Since the active investors who outperform and underperform will often trade places from year-to-year, my low-cost annual advantage will compound over time, putting me ahead of 70% of all active investors after 5 years, ahead of 80% after 15 years, and ahead of 90% after 25 years.

As Buffett has said, I would rather be certain of a relatively good return than hopeful for a great one.

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Re: Indexing: When being 'average' is a lot better than average

Post by Saphomd » Fri Dec 16, 2016 3:10 pm

Well said.

Gropes & Ray
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Re: Indexing: When being 'average' is a lot better than average

Post by Gropes & Ray » Fri Dec 16, 2016 3:26 pm

I don't see if it says whether fees were taken into account. I have seen data that says indexes are in the 10% over a decade after fees. This would line up with that if they did not take fees into account.
Last edited by Gropes & Ray on Fri Dec 16, 2016 4:06 pm, edited 1 time in total.

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Re: Indexing: When being 'average' is a lot better than average

Post by FullYellowJacket » Fri Dec 16, 2016 3:30 pm

Market timing would be the equivalent of trying to use a driver to get on the green of a par 4 surrounded by sand traps with a lake between you and the green. You may get lucky and end up with an eagle, but you are just as likely to end up in the water which requires you to play even more aggressively to make up shots...




...Basically the end of Tin Cup.

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Re: Indexing: When being 'average' is a lot better than average

Post by Phineas J. Whoopee » Fri Dec 16, 2016 3:46 pm

A very rough explanation I used, with a former colleague who knew enough about markets and investing for it to be meaningful, and had asked me, was:

Imagine a year in which the market's return, as a whole, is 8%. With a total-market index fund, there's a little bit of expense along the way, so you might get, say, 7.8%.

Now think about an active manager, who's buying and selling and conducting research and paying for lighting-fast information and assistants to analyze it, in an effort to be better than average, and spends 2% along the way. He has to do 25% better than the market return just for his clients to achieve average.

The point is independent of whether the numbers are realistic or the math subtle.

PJW

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Re: Indexing: When being 'average' is a lot better than average

Post by Phineas J. Whoopee » Fri Dec 16, 2016 3:48 pm

Gropes & Ray wrote:I don't see if ti says whether fees were taken into account. I have seen data that says indexes are in the 10% over a decade after fees. This would line up with that if they did not take fees into account.
Mutual fund returns are always reported on an after-expense basis. Indices, not the funds that try to follow them, have no expenses.
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Re: Indexing: When being 'average' is a lot better than average

Post by Portfolio7 » Mon Dec 19, 2016 1:49 am

I really like the golf analogy, because I think most investors fail to make market average returns, just as most golfers fail to make Par. Not only are there advisors and funds fleecing people along the way, the stock market itself is imbalanced, to the disadvantage of investors in individual stocks. About 75% of stocks have negative returns, while 10% are positive but below average, and 15% drive the market. This seems wrong on the surface, but it's true because stock returns are limited on the downside, but not on the upside. Index funds improve your odds of positive returns immensely. In much the same way, I think there are a few percent of investors who have an edge and make really solid returns. Most everyone else is flailing around, and many get lucky for a short time, but on average they fail to make market averages. Bogleheads, bypass all of that for the most part, and beat 75% of investors. The 25% who get better returns includes 20% who got lucky, and 5% who really had an edge. I'll concede to those guys, and trust to probabilities rather than try to join the 5% or the 20%.
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Re: Indexing: When being 'average' is a lot better than average

Post by mikestorm » Mon Dec 19, 2016 8:17 am

Reposting something I said before on the concept of 'average'
mikestorm wrote:I always hated this argument, as the word 'average', must be viewed in relation with something else (like an array). Focusing on the word without keeping in mind what that word is in relation to is nonsensical.

LeBron James current points per game statistic is 27.1 for his career. If I joined the NBA and purchased an investment that ties my performance to that of LeBron James, and I started scoring around 27.1 points per game, by American Funds logic I've settled for average. Yes. LeBron James' average. I've guaranteed I'll never do worse than LeBron James. I'll take it, thank you very much.

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Re: Indexing: When being 'average' is a lot better than average

Post by carolinaman » Mon Dec 19, 2016 8:29 am

The results of the article are a little misleading and understated in that it includes only funds that were active during the entire 10 year period. How many funds did not survive 10 years? Considering that the 2008/2009 bear market was in the measured timeframe, my guess is there were a lot. This is called survivor bias.

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Re: Indexing: When being 'average' is a lot better than average

Post by David Jay » Mon Dec 19, 2016 9:00 am

Portfolio7 wrote:I really like the golf analogy, because I think most investors fail to make market average returns, just as most golfers fail to make Par. Not only are there advisors and funds fleecing people along the way, the stock market itself is imbalanced, to the disadvantage of investors in individual stocks. About 75% of stocks have negative returns, while 10% are positive but below average, and 15% drive the market. This seems wrong on the surface, but it's true because stock returns are limited on the downside, but not on the upside. Index funds improve your odds of positive returns immensely. In much the same way, I think there are a few percent of investors who have an edge and make really solid returns. Most everyone else is flailing around, and many get lucky for a short time, but on average they fail to make market averages. Bogleheads, bypass all of that for the most part, and beat 75% of investors. The 25% who get better returns includes 20% who got lucky, and 5% who really had an edge. I'll concede to those guys, and trust to probabilities rather than try to join the 5% or the 20%.
And no one knows how to find the 5% IN ADVANCE.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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