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Active Investing Datapoint Of The Day

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by Felix Salmon
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Mar 09 2008 12:00am EDT

Active Investing Datapoint of the Day

The cost of active investing: $100 billion per year, according to Kenneth French at Dartmouth University. That's up from just $7 billion in 1980, you can see why Wall Street has made so much money in the interim. In his annual letter this year, Warren Buffett does a nice job of explaining the mathematics:

Everyone expects to be above average. And those helpers - bless their hearts - will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group - the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group - the "know-nothings" - must win.

Zubin and I debated this subject with Baruch in August. The anonymous Spinozist did make one good point: if you concede that there are consistent underperformers (like, say, the world's central banks) then it's entirely consistent for there to be consistent outperformers as well. Still, as a general rule, if you think you can beat the market, you're wrong.

(Via Abnormal Returns)

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