The Arithmetic of Investing: Embracing the Power of the Market

In 1906, British scientist Francis Galton headed to a farm exhibition. He was interested in measuring the physical and breeding qualities of livestock. On that day, he came upon a contest to judge the weight of an ox. Among the eight hundred participants were farmers and non-farmers from diverse backgrounds. Surely, with such a wide-ranging group, the results would be all over the board.

Galton gathered the tickets from all participants and presumed that, with the wide range of guesses, the average guess of this group would be way off from the actual weight of the animal. Galton calculated the average guess to be 1,197 pounds, nearly perfectly estimating the actual weight of 1,198. This result surprised the famous scientist. While some individual results were far off the mark, the errors canceled out. This phenomenon works not just in statistical games but also in the financial markets every day. The power of this collective wisdom is why the arithmetic of investing is so important.

The arithmetic of investing suggests that it is difficult for anyone to consistently "beat the market." What is the market after all? Stock indices are widely reported in the media, but they are not representative of the market. The market is not the Dow Jones Industrial Average or the S&P 500. The market is the collective portfolio that is the summation of all portfolios of all investors from all walks of life – large pensions, sovereign wealth funds, hedge funds, and mom-and-pop. If a company issues five shares of stock, they are owned by someone, and the market collectively "owns" all five. The market portfolio is everyone's stocks, bonds, real estate, and other assets. 

The math dictates that for every person that owns a larger proportion relative to the market of, say, Apple stock, someone else must hold a smaller proportion. For every investor that outperforms the market, someone else must underperform. Relative performance is a zero-sum before fees. 

In regular times, there is wisdom in the crowd. Millions of investors' judgment, biases, and forecasting errors cancel out, resulting in market prices that are the collective best guess for what all assets are worth. The market is a remarkable and powerful information processing machine. It is a free market at its best.

That's not to say all the return potential is erased through market forces. It just suggests that it's hard to be consistently better than the market.

Empirical data that supports the notion that it's hard to beat the market. According to the SPIVA study, published regularly by the S&P Global, 92% of the actively managed funds lag behind their benchmarks over the long-term. Moreover, it's not the same funds that consistently beat the market, so one simply can't pick top performers and expect the good performance to continue.

In 2013, Nobel Laureate William Sharpe published an article in the Financial Analyst Journal titled "The Arithmetic of Investment Expenses." In it, he illustrates the impact of investment expenses on investment performance. He estimates a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement that is more than 20% higher than a comparable investor in high-cost investments.

Sharpe's article emphasizes the importance of considering investment expenses when selecting investments. He suggests that investors should opt for low-cost index funds that track the market rather than actively managed funds, which are more expensive and fail to deliver higher returns than the market over the long term.

The arithmetic of investing suggests consistent, disciplined investing starts with the market portfolio. With the market as a starting point, you can reduce unnecessary layers, increase tax efficiency, and control cost. We believe this is a crucial first step to simplified financial life.

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