Well, judging from your responses, I seem to have started something with this February 4 comment:

Beating the Market in Two Hours a Day
“I picked up your revised investment guide book. I have to say though that I was a little depressed to read again that you believe that one can’t beat the market over the long haul. I hope that you are talking to the average Joe that spends maybe an hour or two per month thinking about this sort of thing rather than someone like me who spends a couple of hours a day on the subject. If not, then I guess my retirement is a lot farther off than I had hoped (I’m 24).”-Greg King

Sorry Greg. If you could beat the market in two hours a day, why wouldn’t the mutual fund managers who spend ALL day on it be able to?

Joshua Rasiel responds: “Don’t those managers have quotas, and guidelines and official goals and a prospecus that they must follow? Can a mutual fund decide, on a day’s research, to sell everything and go long on Apple? I did. Actually, I’m losing on that one. But I’m going to stick it out a while longer. The point is, mutual funds are not very flexible, are they? And let’s not forget all those overweight jockeys.”

Well, I agree with that latter part about the overweight jockeys.

For those of you new to this space, this refers to the handicap your investment horse has if dragged down by a 100-pound or 150-pound or even 200-pound jockey (a 1% or 1.5% or even 2% annual expense charge on your mutual fund). It’s those jockeys that cause 80% of the funds to trail the dumb old index fund nags, whose managers make no attempt to beat the market at all. They just buy the entire index to mirror it. For this simple chore the annual fee is two-tenths of one percent — a 20-pound jockey.

So Greg wonders whether he can’t “beat the market over the long haul” – which means beating the index funds, with their 20-pound jockeys — and Joshua wonders whether a horse with no jockey at all (well, he’ll be the jockey, but work for free) can’t do better still.

And the answer is . . . well, no. Not often, anyway.

In the first place, actively trying to beat the market, as Joshua is when he sells everything to buy Apple, implies a fair amount of buying and selling. Selling implies taxes. So even though you knock that final 20 pounds off your horse by doing it yourself, you may still have a structural handicap: index funds are tax-efficient. They rarely sell, and thus normally expose you to only modest taxes.

Yes, Joshua and Greg are right, in my view, that they have a reasonable chance of doing a little better than the actively managed funds. If an actively managed fund earns 9% after its 1.5% fees, they might do 10.5%. And that’s nothing to sneeze at. But that extra return comes not from wise stock picking, but from saving the fee.

So why not just use index funds?

Two reasons.

First: it’s no fun. I’m not kidding. That’s why I don’t use them. I do-it-myself because it’s just so darn interesting and stimulating and exciting, and because on some level I think that with all my smarts and experience I really can beat the market. And sometimes I do great (the result of brilliance and insight) and sometimes I do rotten (the result of bad luck or management’s dirty dealing) and when it’s all evened out, I would probably have done better in index funds.

Second, you get to control the tax consequences. (Well you get to control everything. And control is a word many of us know well . . . control, control, control . . . but that goes back to Reason #1.) An index fund is tax-efficient, but it doesn’t give you the flexibility to take specific losses on one or two disasters (up to $3,000 of which serve to lower your taxable ordinary income each year) while letting your profits in the others run. It doesn’t let give your big winners to Alma Mater instead of cash for your 25th reunion gift. (Cash is good, but appreciated securities — stocks that have gone way up that you’ve held more than a year — are the way to make large gifts.)

So there is a case for doing it yourself, now that brokerage commissions at deep discounters are all but trivial. (Note to younger readers: for all of recorded time, until about yesterday, it used to cost the Little Guy a fortune in commissions to buy or sell stocks.) But it is not that you’ll outsmart the pros.

Joshua continues: “I may be down right now, but since I started investing last summer, my portfolio is up about 25%, and during that period, the Dow has flim-flammed all over the place. In fact, I bought very close to the July high, just before the huge correction. And I was still able to profit, because I traded a lot, as I thought neccesary. Not all my trades were profitable. But apparently enough of them were, because I came out ahead. I did lots of research and made as logical a decision as I could on my orders, and I am pretty sure that at least for me, sitting back and letting an index fund make me a reasonable profit would have been unacceptable. That’s why I hate the Motley Fool’s Dow dogs approach. It’s good maybe for someone who wants to invest their cash and forget about it for a year. But if you can spare just a little time to learn a thing or two about the market, you could do so much better! How people can sit around and watch their stocks go down when there are far better stocks in which they could be invested, is beyond me. I can’t do it. If my stock is not performing up to my standards, it’s gone! I’ll find a better one and make my money back, and then I’ll make some more!”

That’s the spirit!

But unfortunately, the markets don’t work that way. In the first place, again, there are the taxes. People have calculated that if Warren Buffett, world’s second richest man, had turned over his portfolio once a year instead of patiently buying and holding — and something tells me Joshua turns over his portfolio even more aggressively — the poor fellow would have had barely 12% the fortune he has today. Compound $1 for 34 years at 26% and it grows to $2,585. Clip 30% off that 26% rate for taxes, bringing it down to 18%, and the same dollar grows to $278.

(In addition to taxes, there are the commissions — trivial but not zero. And there are the spreads. If a stock is 12-1/4 bid, 12-3/8 asked, there is a 1/8-of-a-point “spread.” You get clipped for $125 each time you buy-and-then-sell 1,000 shares.)

And in the second place, the markets are relatively “efficient.” At any given time, so this argument goes, all the available information is “in” the market. Yes, there will be some idiots buying and selling brainlessly, but they more or less cancel each other out (goes the theory). So only if you truly know something important that no one else does — only if, that is, you possess inside information and are willing to risk prison to trade on it — can you beat the market.

This is called the “random walk” theory of price movements, and I commend you to Burton Malkiel’s classic book, A Random Walk Down Wall Street. I don’t totally buy the theory — and neither does Malkiel. He describes himself as “a random walker with a crutch.”

But I believe, as he does, that it’s largely true.

Joshua concludes: “You probably think I must be one arrogant guy.”

No, you sound like a terrific guy. But young, and I don’t want to see you get burned. Or addicted. “A couple of hours a day” is a lot of your life. Are you sure this is how you want to spend it? The answer need not necessarily be “no.” But the question should be asked.

Tomorrow: One final point on this topic.

 

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