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October 19, 2015

Who Should Buy Index Funds?

This is the first of a series of essays about my new style of portfolio management. I must warn that underperformance is the norm in investing. Investing could be the toughest task you have ever attempted, this is certainly true for me.
All forms of wealth distribution, including investing, have a peculiar "average." Normally we think of average as half way from top to bottom or around the middle of a field. We are used to dealing with normal distributions like the height of people or the size of peas. There are many things in nature like earthquakes and wealth that don't have a normal distribution but instead have a power law or Pareto distribution. With a normal distribution about half the people are taller than average and the other half are shorter than average. With a Pareto distribution there are a few large earthquakes and lots of little ones, the top 20% of the population owns 80% of the wealth. This is not caused by underhanded methods but by the very nature of wealth. One hears that 75% of funds underperform the market indexes. If one accepts an index as the "average," then 75 fund managers out of 100 are under average while the remaining 25 are above average, not your "normal distribution!"

What this means for the average investor is that he has only a 25% probability of beating the index by picking stocks. Three out of four investors are better off buying low cost index funds. For most of us the objective of investing is not beating the indexes but of accumulating an egg's nest that will see us through our retirement years. If your portfolio is large enough to meet this requirement using a modest payout ratio, then index funds are a good way to manage your portfolio. For those of us who don't have such a portfolio reaching for better yield is a necessity unless we want to live like hermit monks. A wise first move is to eliminate unnecessary expenses like credit card debt and an extravagant lifestyle. But if that isn't enough then one has to take an active approach to investing.

Picking a mutual or a hedge fund is as difficult as picking individual stocks. About three out of four funds underperform the indexes just like individual investors do. To pick one make sure they have a long term history of outperformance, switching funds based on the latest performance data is an almost assured way of underperforming.

The next installment: How to Pick Stocks

Denny Schlesinger

Why Does the Average Mutual Fund Underperform? A look at the consequences of a Pareto distribution

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Last updated October 18, 2015.