Sunday, December 3, 2006

knowing less sometimes means making more

Today I started reading a fascinating book, James Surowiecki’s The Wisdom of Crowds (Anchor Books, 2005). This is a best-selling business book written by a journalist who not only writes well but also gets things right. The counter-intuitive premise of this book is that the collective wisdom of people operating independently is very often superior to the individual wisdom of experts. There are some seemingly strange, out-there examples (terrorist threats, predicting elections) but also the more mundane examples of betting point-spreads, parimutual gambling (e.g., horse racing), financial markets, futures markets, even estimating the number of jellybeans in a jar.

The results are well known, or should be, to economists. However, Surowiecki is not an economist but a journalist. He presents the ideas in what I find to be a novel and interesting way while making them accessible to people unfamiliar with them.

Yesterday I read an interesting article (“Limited Menu: Choose Only Three,” The Wall Street Journal, 2 December 2006, p. B4) about a simple way to outperform stock pickers, investment experts, and mutual fund managers: just divide your money between three indexed mutual funds for domestic stocks, foreign stocks, and bonds.

An indexed fund has a portfolio or collection of stocks that simply mirrors a market index. An index is just a sort of average of stocks that reflects what is happening in a particular part of the financial market. Examples of indexes you may have heard of are the Dow Jones Industrial Average, S&P 500, NASDAQ Index, and Wilshire 5000.

The evidence that market experts do not beat the market, as measured by overall averages or indexes, is overwhelming. Over the last five years, over two-thirds of all mutual stock fund managers have failed to beat the market. 95% of bond fund managers failed to beat indexes. Over the period of 1984 to 1999, 90 percent of stock fund managers failed to beat the market.

Non-experts do even worse.

So why buy managed mutual funds to under perform the market when you can just buy the market? To do this, buy an index. It is just a small fraction, a representative slice, of the market.

Why do stock market index mutual funds beat the experts? First, they have low management fees, almost a percentage point below the average mutual fund fee of 1.4%. The fees are lower because they can have a computer manage it cheaply and there are fewer expenses due to less turn over (buying and selling of individual stocks) than a managed fund. In a very competitive market, an extra margin of 1% means a lot. Second, indexed funds have no sales fees – at least no competent investor would buy one that did. Third, index funds utilize the wisdom of crowds.

The book gives a better explanation than I could, but here is a very short one. With large numbers, markets tend to aggregate or sum up the private knowledge (information, hunches, intuitions) of many individuals. Also with large numbers, some overestimate while others underestimate, but the different errors of many individuals tend to cancel each other out.

Index funds have less risk. This is a good thing and is due to greater diversification, having money spread out over a large range of things. As a result, you will always do just about average, no better, no worse. The downside is you will not ever get to brag about great returns on your stock picks. The upside is that over the long run you will outperform the vast majority of the pros as well as just about everyone else.

Would you rather be able to every once in a while, occasionally brag, impressing people who don’t know any better, or always retire richer?

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