For the vast majority of things we encounter in life, average means something along the lines of:
“In the middle”
Average is something you might settle for, given constraints such as time or money, but it is rarely something you strive to achieve.
Whether we’re talking about academic performance, dining out, or our investments, no one wants results that are inferior to half of the group.
Instead, we want a 4.0 grade point average, a five star restaurant experience, and a portfolio that handily outperforms the market.
This outlook on life pushes us to work harder, innovate, and constantly seek to improve.
In fact, it’s part of the American culture. And, in most circumstances, it’s a good characteristic to have.
However, when it comes to investing, this approach causes most investors to perform worse than average.
The reason is simple: average isn’t average in the world of investments.
Let me explain.
In investing, average is typically used to describe the return of a market or an index.
For example, the performance of the S&P 500 represents the average return (in this case, the market-cap weighted average return) of the 500 largest publicly traded companies in the United States.
However, simply saying that investing in an S&P 500 index fund will deliver average returns doesn’t tell the whole story.
Specifically, there are two critical differences between investing and almost every other competitive activity.
These factors mean that investing must be viewed differently than sports, academics, or fine dining.
To illustrate, let’s look at both of these differences by comparing investing to running a marathon.
In a marathon, every participant must compete and those who want a chance to win must train like a pro.
The rules of any marathon are very simple:
If you want to complete the race and receive a time, you must run the same marathon that every other participant does.
However, simply completing the race guarantees you nothing beyond a last-place finish.
Any runner who actually wants a chance at winning must train extensively, eat a controlled diet, and perform well on race day.
If they don’t, the runner is almost certainly doomed to a below average result.
In investing, however, any investor can obtain the market return without any training. In fact, an investor doesn’t even have to compete.
Unlike in marathon running, investing provides a unique opportunity to complete a race without even running.
By investing using index funds, investors can achieve a market’s return without competing against other participants.
No special training, education, or access is required.
All an investor needs to do is choose a fund that replicates the return of the market or asset class they seek.
Of course, investing in an index fund dooms the investor to average returns, right?
When we compare the index (or market) return to the returns of other investors, we see that this is not at all the case.
Rather, the market return of an index fund generally outperforms 60% to 90% of its competitors (funds that attempt to beat the market).
This brings us to point number two.
In a marathon, training has a direct and positive impact on results.
Although the correlation may not be a perfect one-to-one, effort and expenses related to training generally have a direct, positive impact on a runner’s performance.
For example, better coaching and superior shoes can be expected to benefit a competitor.
Additionally, when one competitor trains for a marathon, he or she does not have a net negative impact on the marathon as a whole.
In fact, the average marathon time is likely to improve, as a result of the training.
Conversely, in investing, attempts to beat the market are a negative-sum game.
The fees and expenses incurred when an investor attempts to beat the market reduce the total returns available to investors as a whole.
This means that the combined return of investors who attempt to beat the market must always be lower (as a result of much higher fees and expenses) than the combined return of investors who accept the market return (by investing in an index fund).
See The Arithmetic of Active Management by Bill Sharpe for more on this simple concept.
Thus, the “average” return of an index fund has a spectacular track record of outperforming the vast majority of those who deviate from an index or asset class approach.
So next time you hear someone denounce the “average” returns of an index, be sure to remind them that when it comes to investing, average is anything but average.