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Above Average Chances of Being Below Average

by Adam Spiers on July 30th, 2011

The vast majority of us think we are better drivers than average, with above average intelligence. Obviously, this can’t be right.  Similarly, most investors think they will beat the market average.  In fact, the opposite is true – most investors HAVE to underperform the market, by definition.  The market’s average return is the net sum of all investments before the costs of those investments. These costs, it turns out, are substantial.

Investors incur heavy fees, such as the fund’s expense ratio (usually listed in a fund’s description and averaging 1 or 2 percent).  But these are only the most explicit costs, there are also: brokerage commissions, sales loads (which Community Ladders HATES), advisor fees, and the costs of portfolio turnover.  Pretty soon your 1 or 2 percent mutual fund is really costing 3 or 4 percent.  With those kinds of costs, you need to do 3 or 4 percent better than the market to actually achieve market returns.

Advertisements from investing firms, however, will try to persuade you otherwise. Such advertisements will promise that they have broken the old paradigm and have a foolproof strategy. They’ll support their view with recent results (more likely than not, based on returns before costs are subtracted). Ultimately, however, we know the vast majority of mutual funds will not achieve the market average over the long term.

A Note From Bill Varettoni, C-L’s Founder:

At Community Ladders, our investment strategies take their cue from rigorous academic studies of the stock market. We don’t believe in ‘beating the market’ or timing the market. Because we use rational analysis, we believe the best course is to try to track market returns as closely as possible. We do this through index investing, meaning we invest in low-cost funds that buy and hold hundreds of stocks in a given market segment. Fees are low because the fund isn’t buying and selling – it’s buying and holding for the long haul.

Contrast the expense ratio of a typical index fund (0.25%) with some of the actively-managed funds in your 401K (1% or greater). We guarantee you’re holding a number of funds with expense ratios greater than 1% and a mediocre track record of performance, because the vast majority of 401k programs only offer a selection among a few active funds that have relatively high expense ratios.  But don’t feel too bad – you’re doing about the same as most everyone else. Nevertheless, you should still be contributing enough into your 401k to get your full company match.

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