The following table and chart are re-creations of a table and chart published in John Bogle's Common Sense On Mutual Funds. I believe that a short analysis will explain the argument for long term investors to simply hold the total market versus paying active managers to pick stocks or sectors.
A review of the chart shows that the average 1 year US stock market return since 1802 has been 6.5% (adjusted for inflation) with a one year high of 61.4 and a 1 year low of -48.4.
It also shows that as time passes the average return on the US stock market goes up and its highs and lows go down. For example the average of all 25 year holding periods is 6.9% with a high of 11.1% and a low of 2.7%. That means that any investor that held the US market for any 25 year period never had a 25 year return higher than 11.1% or lower than 2.7%. The numbers for a 50 year holding period are even more dramatic.
Now I need to bring in the definition of standard deviation to fully make the argument for holding (or indexing) the total US market.
Standard deviation measures the spread of the data that makes up the average. So a larger standard deviation means that the data that make up the average are spread farther apart than lower standard deviation averages. The chart and table above demonstrate this: in any 1 year the US market had returns that could have been anywhere between 61.4 and -48.4. But if one held the US market 50 years the spread of returns ranged between 3.9 and 9.9 (the 50 year holding period has a lower standard deviation).
Stay with me.
Statisticians have found that most averages have data that falls within 3 standard deviations (SD) of the average and that the data points make up a "bell shaped curve"
The graph below shows this idea. Generally, 68.2% of the data points that make up the average fall within 1 SD, 95.4% fall within 2 SD and 99.6% fall within 3 SD. Standard deviation is represented below by the Greek symbol sigma ( σ ).
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3.9%... 4.9% ...5.9%.. 6.9%.. 7.9% ..8.9%...9.9%
Average return for the corresponding standard deviation for 50 yr holding period
So what does all this mean for long term investors? It means this: If you had simply held an index fund of the total US market over the last 50 years you would have earned 6.9%. You would have had a fee of .20% (index funds are very cheap - there is no work to do) and your net after inflation return would have been 6.7%.
If you paid an advisor to actively manage your investments, or used an actively managed mutual fund, you had a 50% chance of being above average. Now factor in fees of 1.5% (average of mutual fund or personal advisor fees) and you would have had to had a return of greater than 8.2% (8.2% - 1.5% fees = 6.7%) to equal the return of holding the index and just being average.
Note: that actively managing means that someone is picking stocks and buying and selling based on what they feel is the best time to move in and out of certain stock positions.
If you earned an 8.2% return you would have been in the greater than 1 standard deviation range. Remember for the 50 year time period the standard deviation was 1%. A look at the graph above will show that your return would have been in the top 10 to 16% of returns.
Anything less than an 8.2% return and your performance is less than average after fees.
As an investor you need to ask: what are my odds of achieving higher than average net returns?
Finally, I want to emphasize that studies also show that the stock picker or mutual fund that does great one year or for several years does not maintain that position. So, to add to the above question, one needs to ask: can I consistently pick the advisor, mutual fund or stocks that will, net of fees, outperform the average of the US stock market.
My advise: ACCEPT AVERAGE and by doing that you are FAR ABOVE AVERAGE, NET OF FEES.
In further blogs we will explore what stocks tend to fall in the above average part of the bell shaped curve and why. Preview: they do not get there without a cost, and that cost is volatility - risk.
