Beat 90% of Investors: The Only Long Thesis We (Probably) Need
You either earn or pay compound interest. Earning it is preferable, easier and more fun than paying it.
We are linear thinkers and money operates in higher order plane. It compounds (up or down). For this reason, we often think we are winning when we are actually losing.
Active management is statistically costly in the long run. Passive management (indexed investing) is not and enables anyone to capture market returns with minimal sweat.
I believe Einstein once said that you either earn or pay compound interest. I don´t think I fully understood this until I read John C. Bogle´s “The Little Book of Common Sense Investing” this week. In this book, Bogle dissects a very simple truth, which is that most active management funds do not outperform their equivalent indexes and that you can beat ~90% of investors by simply opting out of the game.
Active fund managers charge fees and turnover large parts of their portfolios yearly, which leads to paying taxes. So for instance, consider that in a given year a manager that you have selected performs 11%, whilst the market performs 9%. Since you have to pay fees to your manager, the performance you end up getting is 11% - costs. Suppose the cost is 1.5%, you end up getting 9.5%, which just over performs the market. This would be a fairly reasonable scenario and could very well repeat itself for a number of years.
The thing is that most managers fail to outperform the market over the long term and in actuality, what you are statistically likely to end up doing is simply pay yearly fees only to end up underperforming the market over the long run. In this way, you end up paying compound interest.
Why? Because the difference between say returns of 9% yearly and 7% yearly compounds over time and you end up getting exponentially more money if you obtain yearly returns of 9% vs returns of 7%. Conversely, you pay a hefty price for obtaining returns of 7% vs 9% yearly. The difference in the resulting amount 20-30 years down the line, for instance, is considerable. Consider the more visual example below.
Bogle goes on to explain how funds that outperform the market for a certain period are statistically unlikely to do so the next and viceversa. It seems that over-performers become under-performers and viceversa, each one tending to revert to the mean through time. Some funds turn out to be exceptional, but there are not many of them. They are easy to spot in hindsight but not so much so in foresight.
The above applies equally to stocks and bonds. It is hard to beat the market over the long run and in fact, the long run is made of a series of short runs. So even though it sometimes looks like we are winning, we are actually losing in slow motion. This is a strange and abstract concept because our brains can only think in a linear fashion and we are almost always unable to see the bigger picture. You can have great wins over years and then in a bigger time span, of a few decades for instance, still be paying compound interest rather than earning it. This is the cruel and fascinating fashion in which the market operates.
Having said this, it is possible to make plenty of money through active strategies. Paraphrasing John Maynard Keynes, the game is about buying assets under their fair price and holding onto them through thick and thin. I kickstarted my investing career by buying $AMD and $SCTY (SolarCity, now Tesla) back in 2014. Both have gone phenomenally well, but replicating this level of performance will surely be tricky. Nonetheless, the framework Bogle provides is to markets what gravity is to our 3 dimensional earthly reality. If we buy and hold the market over the long run we can guarantee that we will obtain our fair share of returns and in doing so, beat 90% of our investing (also trading) peers.
We cannot ignore the implacability of the power of indexed investing and how far simpler and superior it is to plenty if not all of the flashy and costly alternatives that demand our attention daily. Most people out there that are thinking about investing are far better off by going down the path of indexed investing. What is perhaps most fascinating about this strategy is that it is so compelling, that one could easily throw not billions, but trillions of dollars at it with considerable peace of mind. In essence, by going long the SP500 you are going long humanity. If you believe humanity is going to prosper, the SP500 is also very likely to keep appreciating in value. If it doesn’t prosper, the SP500 depreciating won´t be much of a going concern anyway.
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