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Don't just do something, stand there!
On Warren Buffett, Peter Lynch, and the virtue of doing almost nothing at all
"Beating the market" is the kind of act that makes an investment professional "legendary". To out-perform the stock-market averages (and to do so with consistency) is an uphill climb, but Peter Lynch can credibly claim to have done it during his time as a mutual-fund manager at Fidelity. Lynch's success at managing funds even turned him into an author -- of books that unabashedly crow about "Beating the Street" and putting the investor "One Up on Wall Street".
■ Given his credentials, it should come as no surprise that Lynch remains a proponent of active investing -- that is, of paying money managers to make decisions about specific investments and the specific timing of those investments, as opposed to "passive" investing, which consists of buying and holding stocks and other investments, often through tools like index funds.
■ In an interview, Lynch argued that three managers at Fidelity "have beat the market for 10, 20, 30 years, and I think they'll keep on doing it." Lynch further used the word "mistake" to typify passive investing strategies.
■ It is absolutely possible for an active money manager to beat the market. The laws of large numbers and averages ensure that -- some people will be above average. But if the ordinary retail investor is smart enough to pick the right managers, then he or she is also smart enough to simply do the investing themselves, directly. That's the paradox: Being sufficiently knowledgeable to thoughtfully select an active investor is the same level and type of skill as being able to perform the investment for oneself. People may still choose not to do it for a variety of reasons -- lack of time and lack of interest, chiefly -- but evaluating a mutual fund's performance requires precisely the same skill set as evaluating an individual company's stock.
■ The wisdom of passive investing (generally through stock index funds) isn't that it will produce special returns, but that it will produce average returns while keeping the overhead costs to a bare minimum. Unless your active money manager is one of the Little Sisters of the Poor, they're charging significant overhead fees.
■ To pay for an annual money management fee of 1%, 2%, or more, and still achieve a total return for the investor that is equal to the market average, the manager needs to consistently produce returns that exceed the market average by the amount of the overhead. And they can be very good at giving investors lots of glossy pictures that keep them from seeing whether that outperformance occurs.
■ The most efficient way to tell whether a money manager is serious about producing consistent, super-sized returns is to look at the fee structure. If you, the investor, only pay a commission or fee for returns which are in excess of the market average, then they're serious. That was how Warren Buffett structured his early investment partnerships -- and Buffett today is a steadfast proponent of passive, index-fund investing.
■ But practically nobody has a Buffett-style, pay-only-for-above-average-performance fee structure, because money management all too often counts on investor naivete -- or innumeracy. After all, "1% of assets" sounds like a small charge -- until a year of 5% real returns, in which case that 1% is actually a 20% commission on total performance. (And activity itself is costly -- someone's making money every time a stock changes hands.) Moreover, the only thing worth paying for is performance that's better than what could have been achieved on investing autopilot -- simply going along with the market average.
■ Nobody likes to be "average". Human nature wants to be better than average. But "average" is generally really, really good in America: That upward-charging line of the S&P 500 graph is "average", and it costs virtually nothing to be a free-rider on that average. Vanguard charges 0.04% to passively follow along with that hard-charging S&P 500 index. Even if you compounded that 0.04% cost annually, it would take 23 years to reach the same 1% as an ordinary active-management fee for one year.
■ If you're not equipped to examine actual SEC 10-K filings or strategically read the part of a prospectus that's printed on lightweight paper in black and white in the back (and not the colorful parts on heavy glossy stock in the front), then you don't really have the right tools to pick an active money manager. And if you do have the ability and interest to read a 10-K or to evaluate a balance sheet, then you probably are sophisticated enough to pick a bundle of 10 to 20 stocks and be your own active money manager (minus the annual fees).
■ Peter Lynch has a legendary track record on Wall Street. But that doesn't make him an oracle of fiduciary wisdom for the household investor. It's not that some managers won't be well above average -- even Warren Buffett is happy to name a few. But predicting with confidence who they will be takes the same type of skill (and much the same degree) that it takes to do the same task. Buffett remains right on this matter: For most people, most of the time, being average (and paying very little overhead for the privilege of being average) is actually very rewarding indeed.