Many financial websites, blogs and even experts such as Warren Buffet have advocated for the use of Exchange Traded Funds (ETFs) for less sophisticated investors.
The general idea is that being new to investing, newbie investors may not have enough knowledge, experiences and the right strategies to be able to capitalise on the best stocks that can deliver them higher returns.
Hence, instead of focusing their attention on outperforming the market (get higher returns than everyone else), these new investors should focus on getting the market return (get the return that everyone else is getting).
As an investor, which do you prefer?
Option A (Active Investing): To be earning more than what everyone else is getting, at the risk that you may also get less
Option B (Passive Investing): To earn the average return that everyone else is getting
The other consideration is that even if you want to earn more than what everyone else is getting, would you be able to do so.
Using A Fund Manager Via Investing In Unit Trusts/Mutual Funds
One way new investors can outperform the financial market is to invest their money with a fund manager via a mutual fund/unit trust. Most active funds focus their attention not only on making money, but also to outperform the market. Some do, but many others fail to do so.
One of the reasons why these funds may find it difficult to outperform the market, in spite of their experience, is because of the fees that they charge. Fund managers and their employees have to make a living to cover their overheads. Hence, they charge investors a “small fee” for their services in managing the portfolio.
However, this “small fee” also works against both the fund and the investor. If a fund charges an annual management fee of 1.5%, and the market return is 4%, a fund needs to generate an average return of least 5.5% per annum to deliver value to its investors.
Guessing The Weight Of A Cow
In July 2015, National Public Radio (NPR), a multimedia news organisation and radio program producer based in Washington, DC did an experiment. They asked their readers and listeners a simple question.
How much does this cow weigh?
Source: David Kestenbaum/NPR
The idea behind this experiment, as explained by NPR, was to find out how good the collective guess of the (uninformed) crowd would be.
Over 17,000 people responded with the average guess being 1,287 pounds.
The cow weighed 1,355 pounds. So, the average guess was off by 68 pounds (5%). Not too bad considering that by and large, most folks are unlikely to have any clue how heavy a cow would be.
The more interesting insight that was obtained from this experiment was that self-described cow experts actually did fared worse than the crowd, with an average guess of 1,272 pounds, off by 83 pounds (6%).
To find out more, do read the full article on NPR.
What This Means For Investors?
In 2007, Warren Buffet did a similar experiment when he betted $1 million against Protégé Partners that hedge funds won’t outperform an S&P index fund. He won.
The idea, similar to guessing the weight of a cow, is that the overall market may be a better bet compared to the selections made by individual experts.
If you were to guess which group, uninformed crowd or cow experts, would come closer to guessing the weight of a particular cow, it would seem logical that cow experts are more likely to get it right. But as seen in the experiment, given a large enough amount of people guessing, the wisdom of the crowd cannot be ignored, and can actually outperform individual experts.
Of course, this isn’t to say that individual experts cannot beat the collective wisdom of the crowd. They could, and we are sure there were many who have done so. But without the benefit of hindsight, there is no way to know which of these “experts” would make a more accurate guess compared to the collective guess of the crowd.
This same logic applies to mutual funds and unit trusts. Some funds will outperform the market while others will not.
But since there is no way to tell which funds will outperform the market and which would not, prior to investing in them, along with the fact that there will be survivorship bias (i.e. bad funds that underperform will exit the market), newbie investors may be better off investing passively in index ETFs, until at least they learn more about investing for themselves.
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