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Meir Statman: What investors really want--Searching for beat-the-market money managers

Think of investments as ingredients of a stew, some with fat returns and some with lean. Now think of the investment market as a giant well-mixed vat of stew that contains all investments. Some investors dip their ladles into the stew and fill them with fat and lean in proportions equal to the proportions in the market vat. These are index investors who buy index funds that contain all investments. Index investors pay the expenses of their funds, but they can easily find index funds whose expenses are very low, equivalent to a few teaspoons of stew taken out of their ladles. Index investors tend to be buy-and-hold investors who trade only infrequently, as when they invest savings from their paychecks into index funds during their working years and withdraw them in retirement.

While index investors are satisfied with returns equal to risks, beat-the-market investors search for returns higher than risks. Some beat-the-market investors choose handfuls of investments and trade them frequently, hoping to fill their ladles with more fat returns than in the ladles of index investors. Others buy beat-the-market mutual funds, exchange traded funds, or hedge funds, hoping that their managers would find stocks with fat returns. But not all beat-the-market investors can be above average. The ladles of index investors are filled with average amounts of fat returns. If some beat-the-market investors fill their ladles with above-average fat returns, other beat-the-market investors are left with below-average fat returns in their ladles. Moreover, the expenses of beat-the-market investors are higher than those of index investors because beat-the-market investors pay higher costs of trading and the higher costs of beat-the-market managers. Beat-the-market costs are substantial. By one estimate, investors would have saved more than $100 billion each year by investing in low-cost index funds and foregoing attempts to beat-the-market by on their own or by paying money managers to do it for them.

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