Before you freak out and scream – “no it hasn’t you idiot, my situation is different,” let me explain that you are absolutely right, but that has nothing to do with the point. What I mean is more like, I have a very simple approach that will work (although there can never be guarantees) and if you don’t have VERY, VERY, VERY unusual considerations that deviate from the norm, its fairly easy to lay out the basic formula for what you should do, and it will work for 95% of you.
We will lay out that formula in a more concise way in a later part of this series, but we can start with the first major idea here, and it is this – If there is nothing extraordinary about your setting, when all else it equal, the approach with the lowest cost is better. The most famous advocate of this position is, without a doubt, John Bogle. The inventor of the low-cost index fund and founder of Vanguard has labeled this The Cost Matters Hypothesis (CMH).
If you ever sat in a finance class for more than 5 minutes you almost certainly heard of an earlier idea known as the Efficient Market Hypothesis (EMH). The EMH serves as the fundamental building block for virtually all of the financial theory covered in an introductory Finance course including the Capital Asset Pricing Model, the basis of Portfolio Theory, and the idea that risk is connected to return. While we have discussed each of these ideas at length in other posts, the simple version the EMH can be written as: “In an efficient market, the market price of an asset reflects all of the information known about that asset at that moment in time.” If your response to reading that last sentence was “no-joke Sherlock,” then we are in fundamental agreement. However, its not really that hard to argue that there are moments, such as bubbles and panics that strongly suggests that markets are not perfectly efficient, and the Efficient Market Hypothesis will always feel incomplete.
Bogle argued that while the evidence for the EMH is very strong and it is wise to accept it, the evidence for his CMH is far stronger, and it would be foolish to deny it. In a nutshell, it is this. Returns are generated and distributed among investors. Any costs incurred along the way have to come out of the investor’s pockets (either directly or indirectly). As a result, as long as 2 – 1 = something less than 1 it MUST be true that costs reduce what the investor ultimately ends up with, so cost matters.
When comparing the EMH with the CMH we have to admit that the EMH has strong evidence, a sound explanation, and is mostly true. However, the CMH has overwhelming evidence, an obvious explanation, and is tautologically true – meaning that it is true by construction. (For a more detailed discussion see Lo, and Foerster’s book “In Pursuit of the Perfect Portfolio, 2021 Princeton University Press.)
If 100 people each invest $100 in something and the market price of that asset rises to $101, none of those 100 people will actually see all of the extra $1 if any cost is deducted along the way. Thus, cost matters, and if all other things are equal, having lower cost has to be a better deal.
A bit of history may aid in understanding here, and also explains why the fight against cost is about more than this simple math. Bogle frequently referred to the story of the Massachusetts Investment Trust (MIT). This was one (and arguably the first) Mutual fund in the US. I emphasize the word “Mutual” because the creators, first owners, and managers of the MIT started it with their own money, kept their own money in the fund, and later invited other members of the public to join in. As a result of this structure the owners, investors, and fund managers all shared proportionately in both the returns and the risks of the fund.
In comparison, almost all so called “Mutual” funds today are not truly mutual, because the fund manager gets paid (without risk) regardless of fund performance. Over the past 70 years or so this has led to higher fees, higher risks, lower tax efficiency, greater fund turnover, and a setting in which when the fund does really well, the manager gets rich, and when it does poorly the manager stays rich, and the investor absorbs all of the damage.
Bogle argued that the only way to get around this incentive problem was to remove the manager from the equation. Charge no management fee, have a trivial algorithm such as “mimic the overall market” stand in for the decision maker, and minimize costs so that the investor gets all of the benefit – or at least as close as possible. As a result, the effort to avoid costs also removes the incentive structure that distorts your return, giving you less than the market would provide.
You may notice that I did NOT refer to this as “passive” investing. An index fund is not truly passive – decisions are being made and daily rebalancing is being executed. When asset prices change over the course of a trading day, the fund holdings have to be adjusted to bring the fund composition and value back in line with the underlying index. The key point is that the investor knows in advance, the exact impact of these trades, no costs are added, and no managerial emotion or “hunches” are ever involved in this process.
As a practical matter, one obvious justification for this strategy is that there is NO rational reason to believe that your fund manager is going to “beat the market” where this means “consistently earn returns that are not explained by the riskiness of the portfolio”. Let me repeat this. THERE IS NO RATIONAL REASON TO BELIEVE THAT YOUR FUND MANAGER IS GOING TO BEAT THE MARKET. If this is true (as has been demonstrated thousands, upon thousands of times) then the optimal strategy is clear – buy the entire market while paying no fees (or as close as you can get to 0%) in the process. This way you get the market return and there is minimal loss due to unjustified costs.
This idea is the first cornerstone of support for our larger idea that the investment problem has been solved.
Let me close where we opened. We are not saying that your extraordinary skill at doing whatever it is that you do should be ignored. If you are the best in the world at some activity and you can find a way to invest in yourself as you leverage that skill – have at it. That is a fundamentally different approach to the problem, and we applaud it whole-heartedly. One such skill might be the ability to pick stocks better than Warren Buffett. If you have that skill, bet it all on you and get rich. If you don’t have that skill (and YOU DON”T) then you had better come up with an extraordinary argument to explain why your approach is better than the one that we are suggesting here.
