Do you need a sandbox to play in to see if you can beat the market?
Posted on May 31, 2019
If you’re a diehard nest egger you only invest in Index funds. But some just can’t avoid the lure of trying to beat the market. Or just can’t make the switch to Index funds all at once. If you are hooked on trying to beat the market, this post recommends you open a new, tax deferred account for your Actively managed funds, ETFs or stocks and bonds. Put a small portion of your portfolio in the account. That allows you to continue to play the game of beating the market at a much more constrained level. You can clearly measure how good you really are.
== Nest Eggers and Index funds ==
Four Index funds do it for Patti and me. There’s no need to get more complex than that. The evidence tells me that over time Patti and I will be better than the 94thpercentile of investors in Actively Managed funds. We’ll beat 100% of those who pay a financial advisor on top of fund fees. That’s good enough!
== Actively Managed funds aren’t good for us ==
Actively Managed funds damage the integrity of our financial retirement plan. Our plan looks like a hockey stick and a pile of money. We’ve made the three key decisions that have LOCKED in 1) the number of years of zero probability of depleting our portfolio in the face of the Most Horrible sequence of stock and bond returns in history – the shaft of the hockey stick – and 2) the amount of money that we would have over time if returns aren’t Most Horrible.
Actively Managed funds distort the shaft of our hockey stick. We don’t know from one year to the next how they will perform relative to market returns. We’ve lost our ability to predict shaft length. That means we can’t find and trust our Safe Spending Rate (SSR%) and Safe Spending Amount (SSA). About the last thing you want to do is add more unpredictability on top of future market results.
Actively Managed funds shrink the pile of money. Their Investing Cost on average is at least four times the default cost assumed by my favorite Retirement Withdrawal Calculator (RWC). Plug in the average cost of Actively Managed funds as an input to the RWC and you can see the pile of money shrink. Big time. (See Chapter 6, NEC.)
== The lure of trying to beat the market ==
The evidence tells us we win the game, beating at least 94 percent of all investors by sticking with Index funds. Yet it’s not easy to accept Index funds. With few exceptions, the financial industry is geared to telling you that you can beat the market. And our brains fight the decision to only invest in Index funds. I describe this problem here. We’ve view ourselves as smart, competitive and successful. Even though the evidence is that we’ll be better than the 94thpercentile of investors, we just can’t accept returns that are a tiny bit less than general market returns. That just doesn’t feel right to some folks. They can’t resist the lure to try to beat the market.
== A “Sandbox” account ==
If you’re lured, I suggest you open an account in your tax deferred, retirement accounts and label it “Sandbox.” (It would take me less than five minutes to open a new account in my Retirement Accounts at Fidelity and then nickname it as “Tom’s Sandbox.” That’s what I’d see every time I logged in and looked at my Portfolio Page. I would also similarly be labeling Patti’s display of my account correctly.)
Then sell securities from another similar retirement account – you have no tax consequences for these sales – and transfer the money into the Sandbox. Make this your playpen for your experiments with Actively Managed funds, special-focus ETFs, or your choice of hot stocks if that is your cup of tea. Over time you will see how well your Sandbox account performs relative to your (in my case) “Tom’s Index Stocks” or “Tom’s Index Bonds”.
The only caveat I would recommend is to start out with a small portion of your total portfolio in your Sandbox. I’d suggest no more than 5% of your total. You may be lucky enough to be in the category of Happy Campers described in NEC, Chapter 5 with More Than Enough for their spending desires. Use some of your More Than Enough in this account. (You may have better choices as to what to do with your More Than Enough, though.)
Conclusion. We retirees should only invest in Index funds. The evidence tells us that those of us who do will be better than the 94th percentile of all investors who don’t follow that advice. We have a financial retirement plan we can count on: we’ll know our calculated Safe Spending Amount (SSA) is indeed safe. But there is a powerful lure to do better. If you cannot resist, I suggest you open an account in your Retirement Accounts that is a Sandbox for you to play in. Keep the sandbox small and measure its performance over time against you much larger holdings of Index funds for stocks and bonds.