Are You an Evil Freeloader Investor?

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Business Insider recently republished a blog by marketing consultant Byrne Hobart that called index investors "evil freeloaders." In that worldview, those of you who own S&P 500 trackers like the SPDR Trust (NYSE: SPY  ) , or broad market trackers like the Vanguard Total Stock Market Trust (FUND: VTSMX  ) , are evil for ripping off active investors.

Truth be told, I'm not sure whether the post was satire, an attempt to seek free publicity, or a very public display of financial illiteracy. In any event, Hobart's expressed sentiment practically cried out for a response.

How does the market get more efficient?
For one thing, for index investing to make sense at all, the stocks that make up that index have to be trading somewhere near their fair values. As the recent "lost decade" amply proved, that's not always the case. But assume for a minute that the market tends to get prices pretty close to right most of the time. How, exactly, do they do so in the first place?

Stock prices get close to right through the actions of the active investors that Hobart praises. For instance, John Paulson buys shares of individual companies like Bank of America or Citigroup presumably because he thinks those shares are undervalued. Or he buys commodity-related securities like the SPDR Gold Trust (NYSE: GLD  ) or AngloGold Ashanti (NYSE: AU  ) because he thinks they're convenient inflation hedges and good ways to play a falling dollar.

The buying actions of active investors like Paulson put upward pressure on those securities' prices, bringing them closer to what these investors consider a fair value. They're not doing that out of the goodness of their hearts, or in the pursuit of an efficient market. They're doing it because they think they can make money. Lots of money. More money than they think they'd get if they were indexers.

You see, if the securities they buy are legitimately undervalued (and the ones they sell are legitimately overvalued), those active investors should be able to get better returns than the overall market. If anything, rather than disparage indexers as freeloaders, those active investors should appreciate the increased opportunities for mispriced securities created by all that "dumb money" chasing the averages.

The numbers racket
Yet even with that active desire to make tons of money, as Hobart points out, active investors tend to underperform their indexing counterparts. In part, that's simply because the market isn't Lake Woebegon. When you're comparing individual investors' performances relative to overall averages, rather than an absolute benchmark, you can expect roughly half of those investors to come in below average, before overhead costs.

Add in fund management fees and frictional trading costs (like commissions, spreads, and taxes), and it quickly becomes apparent why the average active investor underperforms the average indexer after all costs are considered. "Evil, freeloading indexers" aren't the problem. Instead, the underperformance owes largely to the costs of paying those active investors their billions in management fees, atop the simple fact that we can't all be better than average.

Can you do better?
That said, the market can be beaten. As Warren Buffett has pointed out, generations of so-called Superinvestors have beaten the market with value-focused investing strategies. Likewise, even supporters of the Efficient Market Hypothesis admit there's a small-cap anomaly driven by the lower level of institutional investor attention that smaller stocks get.

For any strategy to work for you, though, you've got to ensure the following:

  • Your strategy needs to make logical and financial sense. If there's no underlying reason to believe the strategy will work, then you're relying on chance and the random changes of numbers on a screen. While that might work out, it also might not. Do you honestly believe, for instance, that the production of butter in Bangladesh or the winner of the Super Bowl has any appreciable impact on the overall stock market?
  • You need to be mentally aligned with that strategy. Whatever investment path you pick, and whatever its ultimate potential for success, the market will move against you from time to time. If you're truly aligned with a solid strategy, you can better use the market's inevitable moves to reevaluate your positions and buy, sell, or hold based on logic and data, rather than fear.
  • You need to keep your costs low. If half the world's investors perform below average before accounting for investment fees, then the less you spend in pursuit of your investments, the better your raw odds of winding up on top.

If you put those three factors together, you've got a very good chance of winding up financially secure, whether you're aiming to beat the market or simply match it.

Make sure you understand the basics of smart investing. Check out 13 Steps to Investing Foolishly, and discover everything you need to know to become the investor you've always wanted to be.

At the time of publication, Fool contributor Chuck Saletta owned shares of Bank of America, as does the Motley Fool. Through a separate account in its Rising Stars portfolios, the Fool also has a short position in Bank of America. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 26, 2011, at 5:15 PM, FinnMcCoolIRA wrote:

    Depends in part on individual circumstances.

    If one has accumulated a capital base over the years and can 'live well' with the index average return without either paying all the extra costs of 'trading' (speculating?) or risking a kick in the head, why take the additional - potentially catastrophic - risk?

  • Report this Comment On February 28, 2011, at 9:27 AM, Merton123 wrote:

    I believe that indexing has an advantage based on the science of statistics. The science of statistics is based upon the belief that if you pull a sample that the sample results reflect the population results from which the sample was pulled from. The active investor is trying to pull a sample that doesn't reflect the population return. The law of averages in the long run are in the indexes favor. There are a small group of investors who are able to pull non representative samples that outperform the population average over the long run (i.e., superinvestor). Is this group a statistical fluke?

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