There. I said it.

You’ve probably spent your whole life learning that you have above-average intelligence and above-average work ethic. And, when considering the entire population of people around you, that may very well be true.

But if you plan to pick stocks (or do anything else to beat the market), the group that you’re being compared to is no longer same group. The fact that you’ve been above average at everything else in your life doesn’t necessarily mean much here, because the same thing is true about your competitors.

More important, though, is the fact that this isn’t just about intelligence.

It’s about resources.

Time: They have more of it. They do this full-time. You probably don’t.

And if you’re currently thinking “Sure, I do this in my spare time, but I still work on it for roughly 40 hours a week,” you’re kidding yourself. I’d be surprised to hear of very many fund managers who call it quits after putting in a 40 hour week.

Data: They have more of it. There’s nothing that you can find in your Motley Fool newsletter or Morningstar subscription that they don’t have access to as well.

News: They get it sooner. Many of your competitors are literally on the floor of the NYSE. When something starts to happen, they can react far more quickly than you can.

Don’t worry. I’ve got some good news too.

The good news is that you don’t have to beat the market to be a successful investor. (This concept doesn’t get nearly enough media coverage.)

It seems to be a pretty safe bet that the businesses in our global economy will continue to earn a net profit for the foreseeable future. Capture your share of that profit, and you can build a great deal of wealth.

For the most part, all you have to do is invest regularly, select an appropriate asset allocation, diversify within asset classes, minimize costs….and then not screw up by bailing out on your plan.

Added bonus: It’s actually less work to match the market than it is to underperform it.

I recently finished reading Nassim Nicholas Taleb’s Fooled by Randomness. (Highly recommend it, in case you’re curious.)

At one point in the book, Taleb mentions that, when looking at the outcome of a transaction, our brains are set up to react primarily to whether we’ve incurred a gain or loss–not, that is, to the size of the gain/loss we’ve incurred.

Quick note: I’m certainly not a medical professional, nor is Taleb. So please keep in mind that this information is now at least 2 degrees of separation away from its source.

If the claim is true, it would certainly have some fascinating implications for investing. For example…

We prefer frequent gains to big ones.

And more to the point, we’d most enjoy infrequent losses.

Imagine that you’re given the choice between:

• a portfolio that earns a steady 6% return per year, or
• a portfolio that goes up in 2/3 years, down in 1/3, and earns an effective annual 12% return.

Our brains are hardwired to prefer the first portfolio, despite the fact that our wallets would prefer the second.

Essentially, this gets right at the heart of what I was trying to say a while back: A lack of volatility provides us with a mental/emotional benefit that is real and valuable (though not measurable). And that, in my opinion, is the primary (and perhaps only) reason for including non-equity investments in a portfolio that still has decades to go before liquidation.

Your thoughts?

What do you think? Is that true? Or is there some other reason to allocate a meaningful percentage of a decades-until-liquidation portfolio toward fixed income investments?

A criticism I hear from time to time about the passive investing/long-term buy-and-hold strategy I advocate is that it’s no fun. That’s true. It’s as boring as could be.

There’s no excitement. There’s precisely zero chance that you’ll strike it rich.

There’s none of the fun of checking your portfolio everyday to see how your latest picks are doing. (Quick note: If you are following a buy & hold, passive investing strategy and you’re checking your portfolio everyday, please, stop now. Checking your account daily will do nothing but harm.)

In fact, aside from an annual checkup and rebalancing there’s no ongoing involvement at all–everything happens automatically. (And even the annual rebalancing isn’t necessary if you’re using target retirement funds.)

Want to invest for fun? Go ahead.

If you really want to invest for entertainment’s sake, then by all means, go for it. I completely understand that picking stocks can be fun.

You probably have better odds of coming out ahead than you would if you were to take your money to a casino. After all, even a portfolio of randomly-selected stocks is likely to earn a positive return over an extended period. (Of course, over a short time frame, it’s anybody’s guess what will happen.)

Just be sure, however, not to confuse investing for entertainment and investing for retirement.

Where the real fun happens

In my opinion, however, investing itself is not supposed to be fun. It’s not supposed to be exciting. What’s fun and exciting are the goals that you can achieve using a prudent investment strategy.

I don’t know about you, but for me, the fun I get from having the resources to follow my dreams and do the things I want to do in life far outweighs the fun I’d get from picking stocks.

I recently watched a Ted talk by Dan Gilbert that I can best describe as an entertaining combination of Nudge, Predictably Irrational, and Against the Gods.

One of the things Dan talks about is that, as humans, we’re not very good at judging value. We have a tendency to judge the value of something simply by comparing it to something else in the near vicinity.

One of the examples Dan used to illustrate his point was the following:

People don’t know whether their mutual fund manager is taking 0.1% or 0.15% of their investment, but they clip coupons to save $1 off their toothpaste.

So true! The average shopper has some idea of what a tube of toothpaste costs. If the price were to drop by $2, we’d notice and perhaps buy a couple extra. If the price were to go up by $2, we might buy another brand instead.

In contrast, the average investor has (I suspect) absolutely no idea what he’s paying for his mutual funds. I imagine this is caused by two factors:

1. Fund expense ratios are hidden away in rarely-read prospectuses, and
2. Mutual fund expense ratios just aren’t something that most people spend time thinking or talking about. (But would it really be so strange to bring it up? I mean, people mention it to their friends when they “save” $15 on a pair of jeans, right?)

Price Inelasticity

Economists refer to a good/service as having inelastic demand if consumers continue to buy it at roughly the same rate even when the price increases. The most common example of an inelastic good is insulin. Even if the price of insulin goes up, the people who need it will keep buying it.

It appears that mutual funds prices are fairly inelastic. Sadly, this isn’t because mutual fund managers provide some all-important service.  Mutual fund demand is inelastic simply because people don’t know what they’re paying.

How many people are paying an extra 1% each year without even realizing it, completely unaware that it will cost them hundreds of thousands of dollars over their investing lifetime?

Fortunately, the rise in index fund popularity over the last couple decades might suggest that mutual fund prices are slowly becoming more elastic as investors catch on to the impact of costs on long-term investment results.

Takeaways

First: regardless of which funds you decide to invest in, make sure you at least know what you’re paying for them.

Second: switching to low-cost index funds will save you enough money to buy a lot of toothpaste over a lifetime of investing.

American culture has a deep belief that being average is akin to being a failure. Everybody wants to be above average.

Unfortunately, this desire to be above average rarely works out to our advantage in the field of investing. It leads us to such endeavors as stock picking and timing the market, both of which tend to be counterproductive for most investors.

Index Funds and “Being Average”

As far as I can tell, the primary reason that people are reluctant to invest in index funds is that their egos get in the way.

Ironically enough, with index investing, accepting “average” returns virtually ensures that you’ll come out ahead of the majority of investors.

Another example of ego-related-trouble

What would your thoughts be if I recommended the following investment plan for an investor aged 25?

• 72% in a Wilshire 5000 index fund (tracking the entire U.S. stock market)
• 10% in a European stock index fund
  
• 5% in a Pacific stock index fund
  
• 3% in an emerging markets index fund
  
• 10% in a bond index fund
• Rebalance regularly to maintain this asset allocation
  

A handful of people might say that it’s a bit on the aggressive side. But I bet most people would say that it looks like a fairly reasonable, well-thought-out strategy for a young investor.

Now what if I had made the following recommendation instead?

• Put 100% of the portfolio into Vanguard’s Target Retirement 2050 fund.

I bet many people would have some qualms about such a strategy. They’d say things like, “It’s too simple.” or “Putting all of my money into a single fund just doesn’t seem wise.”

The odd thing is that these two recommendations are the same thing!

Again, our egos get in the way. We seem to have a perverse desire to make investing more complicated than is necessary. We want to feel sophisticated, and putting 100% of an IRA into a target retirement fund just doesn’t fulfill that need.

My suggestion:

Do your best to set your ego aside when making investment decisions. Don’t do something just to feel smart. With investing, the simplest strategy is often the best one.

I just finished reading Nudge by Cass Sunstein and Richard Thaler. The book argues that, often, people would make better decisions if they were provided with a better context in which to make those decisions. For example, studies show that in high school cafeterias, students will make healthier eating decisions if the healthy foods are placed at eye level and earlier in the lunch line than the french fries/desserts/etc.

Makes sense to me.

Thaler and Sunstein go on to explain that there are certain areas of our lives in which we tend to need more help making decisions, and other areas in which we need less help. They argue that in order for people to be able to make good decisions, they need:

• Experience with the subject matter,
• Good information about each of the options, and
• Prompt feedback.

Uh oh. For many people, investing is 0/3 here.

Lack of experience

The typical investor doesn’t have a great deal of experience selecting investments. They’ve only had to do it a few times–when they open an IRA, or when they switch jobs.

Poor information

Generally, the most important pieces of information about a particular investment (portfolio turnover and expense ratios, for example) are hidden in one of the least appealing pieces of reading imaginable–the fund’s prospectus. With a few noteworthy exceptions, this information is not included prominently in the glossy marketing materials.

Similarly, account fees aren’t exactly made obvious. I’d wager that most investors are unaware that their 401k probably charges them another 0.75% – 1% per year on top of what the underlying funds charge. It is, of course, difficult to make an optimal decision without being informed as to the costs involved.

Lack of prompt feedback

Further compounding the difficulty of making investment decisions is the fact that we don’t find out how well we did until decades later, when we’re actually starting to near retirement.

And in fact, there’s an abundance of meaningless feedback that does occur promptly: Oops, the day after you invested, the market went down 5%! Maybe you did something wrong. Maybe you chose the wrong fund. Maybe you invested at the wrong time. Maybe you shouldn’t be invested in the stock market at all!

Or…maybe this feedback is entirely meaningless, and you actually made an excellent investment decision that will pan out well in the future.

No wonder people have a difficult time with these decisions. It’s as if the situation is tailor-made to be difficult.

How to make investing easier for yourself

Of course, there are things you can do to make investment decisions easier for yourself.

To deal with the “lack of experience,” I’d suggest reading.  It’s hard to build up your own investment experience in a short period of time, so why not learn from the collective historical experience of other investors? Read everything you can get your hands on to see what has and hasn’t worked for people in the past.

Dealing with poor information is easy. If you know what to look for (again, expense ratios and portfolio turnover are great places to start) and you know where to look (fund prospectuses), then you’re all set as long as you take a few minutes to actually do the research.

“Lack of prompt feedback,” however, is a tough one to get around. There’s no magical way to get your money to grow faster. All I can suggest here is to make sure you’re not paying undue attention to the prompt (and meaningless) feedback that is available.