begin to offset their transactions costs and their poorly informed, losing
trades. At some point, a trader might become well enough informed to
overcome the transactions costs and match, or perhaps exceed, the market
return. The key word here is mightbecause the number of investors who
have consistently been able to outperform the market is small indeed. And
for individuals who do not devote much time to analyzing stocks, the pos-
sibility of consistently outperforming the averages is remote.
Yet the apparent simplicity of picking winners and avoiding losers
lures many investors into active trading. We learned in Chapter 19 that
there is an inherent tendency of individuals to view themselves and their
performance as above average. The investment game draws some of the
best minds in the world. Many investors are wrongly convinced that they
are smarter than the next guy who is playing the same investing game.
But even being just as smart as the next investor is not good enough. For
being average at the game of finding market winners will result in un-
derperforming the market as transactions costs diminish returns.
In 1975, Charles D. Ellis, a managing partner at Greenwood Associ-
ates, wrote an influential article called “The Loser’s Game.” In it he
showed that, with transactions costs taken into account, average money
managers must outperform the market by margins that are not possible
given that they themselves are the major market players. Ellis concludes:
“Contrary to their oft articulated goal of outperforming the market av-
erages, investment managers are not beating the market; the market is
beating them.”^11
HOW COSTS AFFECT RETURNS
Trading and managerial costs of 2 or 3 percent a year might seem small
compared to the year-to-year volatility of the market and to investors
who are gunning for 20 or 30 percent annual returns. But such costs are
extremely detrimental to long-term wealth accumulation. Investing
$1,000 at a compound return of 11 percent per year, the average nominal
return on stocks since World War II, will accumulate $23,000 over 30
years. A 1 percent annual fee will reduce the final accumulation by al-
most a third. With a 3 percent annual fee, the accumulation amounts to
just over $10,000, less than half the market return. Every extra percent-
age point of annual costs requires investors aged 25 to retire two years
later than they would have in the absence of such costs.
350 PART 5 Building Wealth through Stocks
(^11) Charles D. Ellis, “The Loser’s Game,” Financial Analysts Journal, July/August 1975, p. 19.