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I've seen it said a number of places that investors can never beat the market. Why use investors, then? Why not just put your money in a market index fund?

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    Damn fine question: that's what Malkiel recommends. Though I'm not sure what you mean by "investors" --- aren't you an investor? – Peter K. Sep 9 '16 at 17:24
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    If this question is actually seeking answers about the possible benefits to non-market-index investments, I think it should be rephrased. Right now it seems like a bit of a rhetorical question / argumentative. – Grade 'Eh' Bacon Sep 9 '16 at 17:45
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    Voting to close for being too broad as currently phrased. – Joe Sep 9 '16 at 18:32
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    While most investors do not beat the market (by any significant margin) over the long term, there are some very famous counterexamples (e.g., Warren Buffett). So the statement that you cannot beat the market is simply empirically wrong. That doesn't mean that investing in index funds is a bad idea, however. – Thucydides411 Sep 9 '16 at 20:55
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    You can't beat the market if you put your money in a market index fund. – David Grinberg Sep 9 '16 at 21:08
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Let me start by giving you a snippet of a report that will floor you. Beat the market? Investors lag the market by so much that many call the industry a scam.

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This is the 2015 year end data from a report titled Quantitive Analysis of Investor Behavior by a firm, Dalbar. It boggles the mind that the disparity could be this bad. A mix of stocks and bonds over 30 years should average 8.5% or so. Take out fees, and even 7.5% would be the result I expect. The average investor return was less than half of this.

Jack Bogle, founder of Vanguard, and considered the father of the index fund, was ridiculed. A pamphlet I got from Vanguard decades ago quoted fund managers as saying that "indexing is a path to mediocrity." Fortunately, I was a numbers guy, read all I could that Jack wrote and got most of that 10.35%, less .05, down to .02% over the years.

To answer the question: psychology. People are easily scammed as they want to believe they can beat the market. Or that they'll somehow find a fund that does it for them. I'm tempted to say ignorance or some other hint at lack of intelligence, but that would be unfair to the professionals, all of which were scammed by Madoff. Individual funds may not be scams, but investors are partly to blame, buy high, sell low, and you get the results above, I dare say, an investor claiming to use index funds might not fare much better than the 3.66% 30 year return above, if they follow that path, buying high, selling low.

Edit - I am adding this line to be clear - My conclusion, if any, is that the huge disparity cannot be attributed to management, a 6.7% lag from the S&P return to what the average investor sees likely comes from bad trading. To the comments by Dave, we have a manager that consistently beats the market over any 2-3 year period. You have been with him 30 years and are clearly smiling about your relationship and investing decision. Yet, he still has flows in and out. People buy at the top when reading how good he is, and selling right after a 30% drop even when he actually beat by dropping just 22%. By getting in and out, he has a set of clients with a 30 year record of 6% returns, while you have just over 11%. This paragraph speaks to the behavior of the investor, not managed vs indexed.

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    It's statistics like this which make me happy we live in a time when passive investment is easy and cheap. These statistics are all the more sobering when you consider that most active funds are really closet index trackers. – Nick R Sep 9 '16 at 20:18
  • I think this answer is a little one-sided though. The average result may be poor, but the best (or luckiest, depending on your definitions) managers can beat the S&P by a lot, and there are plenty that beat it by moderate amounts. It all comes down to your risk profile. – David Grinberg Sep 9 '16 at 21:06
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    @DavidGrinberg - you should offer an answer showing the great returns of which you speak. I cited a well known publication by a credible source. Data doesn't lie. Unless you're suggesting that since 1 in XX people might beat the market, it's worth rolling the dice instead of seeking maximum gains with lowest costs. When only an average is offered, it's tough to picture the distribution or returns. Do you figure 1 in 10 are beating the market over time? Less? The 3.66/10.35 disparity has me thinking less than that are above 10. – JoeTaxpayer Sep 9 '16 at 21:14
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    Comments are not for extended discussion; this conversation has been moved to chat and further comments will be cleaned up aggressively. – Ganesh Sittampalam Sep 11 '16 at 8:24
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The market is efficient, but it is not perfectly efficient. There are entities out there that consistently, legitimately, and significantly outperform the market because of asymmetric information (not necessarily insider trading) and their competitive advantage (access to data and proprietary, highly sophisticated models)*. I say this despite most hedge funds performing worse than their respective benchmarks. For most people (even very smart people) it makes a lot of sense to invest in index funds with a reasonable asset allocation (based on desired volatility, tax situation, rebalancing methods etc.).

* The usual example that is cited is RT's Medallion Fund because it has enjoyed quite dramatic returns. Other groups that have been successful include Citadel and Soros Fund Management.

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    There are entities out there that consistently, legitimately, and significantly outperform the market because of asymmetric information"... mind sharing a couple examples? – Mehrdad Sep 10 '16 at 14:07
  • I added an example. – Wuschelbeutel Kartoffelhuhn Sep 11 '16 at 0:11
4

Perhaps someone has an investment objective different than following the market. If one is investing in stocks with an intent on getting dividend income then there may be other options that make more sense than owning the whole market.

Secondly, there is Slice and Dice where one may try to find a more optimal investment idea by using a combination of indices and so one may choose to invest 25% into each of large-cap value, large-cap growth, small-cap value and small-cap growth with an intent to pick up benefits that have been seen since 1927 looking at Fama and French's work.

3

Most of it is probably due to ignorance and disbelief.

A few years ago, I started doing week-long trades with my IRA. For a while I would make money each time, and over the first year I had about a 20% rate of return. If you asked me if I thought I was smarter than other people in the market, I would've told you no - I just spent more time, and most people accepted a small financial penalty for not having to spend the time directly managing their portfolio.

Then I made a few poor choices, and all my previous earnings disappeared quickly. In the short term, yeah, things were great, but that didn't extrapolate out.

So now that I'm a few years into investing, I'm almost entirely in index funds.

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Index funds do leech a "free ride" on the coattails of active traders.

Consider what would happen if literally everyone bought index funds. For a company there would be no motivation to excel. Get listed; all the index funds are forced to buy your stock; now sit on your derriere playing Freecell, or otherwise scam/loot the company. Go bankrupt. Rinse wash repeat. This "who cares who John Galt is" philosophy would kill the economy dead.

Somebody has to actually buy stocks based on research, analysis and value. Company managers need to actively fear, respect and court those people. They don't need to be mutual-fund managers, but they do need to be somebody. Maybe activist investors like Warren Buffett will suffice. Maybe retirement fund or endowment managers like CalPERS or Harvard can do this. Better be somebody!

I'm all for index funds... Just saying only a fraction of the market's capital can be in index funds before it starts into a tragedy of the commons.

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    Not convinced. There is real value being produced by companies and returned as dividends (traditionally) or increased company value and thus increased stock price. If we subtract out trading and just put everyone into a "whole market" pool, they should see "market rate of return", which I believe still has a long-term average of around 8%. That's hardly tragedy of the commons. – keshlam Sep 13 '16 at 6:16
  • But why is that real value being produced? You're ignoring individual motivation. People are not motivated by the altruism of seeing every citizen's index fund go up a tick. They are motivated by cashing out on the fruits of their labor - the hope that their stock will outperform the market. Which requires a robust market of willing buyers who also see the value. That won't happen in an all-index-fund world. – Harper Sep 13 '16 at 11:39
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    The real value is being produced because shares are partial ownership of companies, and companies produce profits. No magic. The "robust market" is not needed in a dividend environment, and not as needed in a value environment as you seem to think. – keshlam Sep 13 '16 at 11:45
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    If companies are merely formed to cash out in the stock market, then they'll optimize themselves for stock market valuation, which means they'll cease to create real value for their actual customers and instead will focus on whatever buzzwords are flying around in investors heads. – yters Sep 13 '16 at 21:32
  • Not that I disagree with your premise, but what's the relationship of your point to the asked question? – davmp Sep 13 '16 at 23:19

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