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To Be or Not to Be Average? Thumbnail

To Be or Not to Be Average?

By Melissa Sotudeh, CFP®

This fall I moved my daughter back to college for her sophomore year.  Of course, my husband and I dispensed a few pieces of advice:

“The career center has a new website and a new director; you should go check it out.”

“What organizations are you planning to join?”

“Do you have a balance of networking opportunities with faculty, alumni, and other students?” 

Not one time did I say, “Be sure to study and go to class.” This was not because my child is an angel, but because that is just expected. That is the average expectation.  In the financial world, there are also certain basics that need to be in place before you can leap from average to above-average.

But a lot of investors are confused about how to do this.

How to Be Average

After I came home from helping my daughter with the college move, by chance my son sent me a Freakonomics podcast that covered exactly this topic.  Investors want to be above average, so shouldn’t they try to beat the market averages with active management?  Well, we wouldn’t recommend it. Active management has very high costs, and investors are paying for a skill no advisor or fund manager can promise to deliver, as shown by academic research.

Kenneth French and Eugene Fama are two highly respected researchers (Fama has won the Nobel Prize) who have collaborated over the years on studies related to efficient market theory, which, in Fama’s words, basically states that “since prices [of investments] reflect all available information, there’s no way to beat the market.” In fact, they found that only 2-3% of active managers had enough consistent outperformance to justify their fee.

So should investors simply settle for “being average”? Well, paradoxically, using an index strategy that might be thought of as “average” actually puts you ahead of the majority of investors—especially those overpaying for strategies that do not work consistently over the long term.

Being Passive Doesn’t Mean Doing Nothing

“You get what you don’t pay for.”—John Bogle, founder of Vanguard

There are many low- cost ways to participate in the markets, and a major one is an index fund-based strategy because they are so inexpensive, yet allow you to benefit from market movement in a diversified way. Essentially, you get the average of all the ups and downs of the index. It has taken a long time for this strategy to catch on, perhaps because this strategy is also called “passive.” Who wants to be passive? Surely being active is better. Well, that’s certainly what those who get paid to trade would like you to think.

When John Bogle created the first index fund, he was the laughingstock of Wall Street. One brokerage firm even published a poster of Uncle Sam with the tagline “Stamp Out Index Funds.”

“The argument is, ‘In America, we don’t settle for average. We’re all above average.’ But, of course, we’re not all above average. But basically, the poster was put out by a brokerage firm. The thing about the index fund — no sales loads, no portfolio turnover. You don’t buy and sell every day like these active managers do. It’s Wall Street’s nightmare and it still is!”—John Bogle

Can an investor be above average without increasing risk?  The answer is yes.  You can add to your return in many ways that are within your control.

How to be Above Average

Just as my daughter takes going to class and completing assignments as the minimum needed to be average, investors need to know the difference between what is a “given” and what will optimize the path toward their goals. Some of the basics include not living beyond your means, having sufficient cash reserves (savings in the bank), contributing to your tax-deferred and taxable investment accounts, and progressing in your career.

But in order to become above average and truly grow your net worth, there are several steps one can take:

  • Keep costs low. You get what you don’t pay for when it comes to investing—because it stays in your pocket to grow and compound over time. Naturally, if you have two identical funds, and one has higher expenses, the one with lower expenses will outperform. This is why we offer our clients Institutional level shares for index funds and ETFs. Institutional shares have a lower cost than the funds available to individual investors (retail shares), but they are inaccessible to most investors due to their high minimums. This is an economy of scale we are glad to offer to our clients!
  • Keep tax-efficiency in mind. Related to keeping costs low, your portfolio manager and CPA should work to find a strategy that does not result in unnecessary taxes.
  • Be diversified. A diversified strategy lowers risk because you are not taking huge bets on any particular stock or asset class. The strategy at Halpern Financial uses diversified mutual funds and ETFs to smooth out volatility of the overall portfolio. Emerging market stocks may do well one quarter, while large-cap stocks may lag behind. The idea is that when one area zigs, the other zags.
  • Control behavior.  Warren Buffett has some very wise advice: “You only have to do a very few things right in your life as long as you don’t do too many things wrong.” Stay disciplined in following your financial plan and try not to get distracted from your long-term goals.
  • Prioritize goals and find a system to achieve them. Following a system is much more effective than relying on sheer willpower to achieve your goals. Rather than putting temptation in your hands to overspend, if you have a particular goal you are saving for, automate your savings.

Note that it does not entail taking a gamble, or being reactive to short-term events. Being above average does not need to entail taking on above-average risk. There are so many ways to accelerate your pace toward your goals!

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