The cost of active investing: $100 billion per year, according to Kenneth French at Dartmouth University. That’s up from just $7 billion in 1980, you can see why Wall Street has made so much money in the interim. In his annual letter this year, Warren Buffett does a nice job of explaining the mathematics:
Everyone expects to be above average. And those helpers – bless their hearts – will
certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below
average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs
they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs
that are very low; 3) With that group earning average returns, so must the remaining group – the active
investors. But this group will incur high transaction, management, and advisory costs. Therefore, the
active investors will have their returns diminished by a far greater percentage than will their inactive
brethren. That means that the passive group – the “know-nothings” – must win.
Zubin and I debated this subject with Baruch in August. The anonymous Spinozist did make one good point: if you concede that there are consistent underperformers (like, say, the world’s central banks) then it’s entirely consistent for there to be consistent outperformers as well. Still, as a general rule, if you think you can beat the market, you’re wrong.
(Via Abnormal Returns)