The Bagel and the Index Fund

(From Jan 2004 Business Week Online)

After a good year for the stock market, a lot of investors are feeling it’s safe to get back in the water. And despite the recent scandals, a lot of money will be going into mutual funds as the economy and market continue to recover. But which funds should you consider?

Study after study finds that indexed funds are superior to managed funds, particularly over a long period of time. In the face of this evidence, why do so many investors still turn to managed funds? Maybe it’s because a lot of people still feel just a little bit foolish buying an indexed fund. How smart can it be to let a computer run your portfolio? How hard can it be to find a manager smart enough to outperform a mindless algorithm?

The emotional and intellectual appeal of managed funds comes from our daily lives, where managing things usually trumps a strategy of letting things take care of themselves. It’s good to organize your monthly bills rather than picking one up whenever you think of it and paying it. It’s good to keep your children away from a hot stove rather than letting them discover the dangers of life by trial and error.

ARMY OF BAKERS. Such real-life experiences can mislead, though, when it comes to some financial decisions. To understand the virtues of an unmanaged indexed fund, consider the world of bagels. Did you ever stop to wonder how it is that in Washington, D.C., where I live, and in every other city of any size in America, bagel shortages never happen?

I know—you’re not impressed. What’s the big deal? But think of the army that has to work together to have that fresh bagel waiting for your random appearance at the local bagel shop. Who coordinates that team? Who told the farmer to grow enough wheat? Who made sure there were enough mills to grind the flour, enough trucks and truck drivers to move it around the country? Bagels have no czar. No one is managing the process. How can bagels be plentiful without someone being in charge?

When the Super Bowl rolls around each January, no one sends out a directive to the flour mill to tell them to grind extra flour for hot dog buns and sub rolls. The Super Bowl comes and goes without a shortage of hot dog buns, and still, there are plenty of bagels.

TOO MUCH KNOWLEDGE. The bagel market doesn’t work perfectly. Sometimes a baker will have an oversupply of one flavor or another. Sometimes I might have to make two stops to pick up enough bagels if I decide to throw a brunch for 50 friends on the spur of the moment. Would the system work more smoothly if someone were managing it?

Strangely enough, the imperfect, unmanaged marketplace outperforms the conscious planning of experts. The Soviet Union was famous for managing its economy into failure. Go to Cuba where everything is managed, and you’ll find everything but despair in short supply. The only times America has sustained shortages is when the government controls prices. In the 1970s, we had gasoline shortages with price controls and an energy czar.

Why can’t a conscious planner do a better job than the unconscious marketplace? The simple answer is that planning for things of that magnitude requires too much knowledge dispersed in too many different brains spread across too much space and time.

BEST STRATEGY. Coordinating that knowledge requires more than an expert with a supercomputer because the nature of that knowledge is often intangible and can’t be reduced to digital information. In the marketplace, prices encourage people to do on their own what a coordinator or planner would have to figure out and command. When demand goes up, prices rise and tell suppliers to produce more. Shortages and surpluses are self-correcting when prices are allowed to adjust freely.

Once you understand how the bagel market, while imperfect, functions smoothly without a manager, you can begin to appreciate the wisdom of buying an indexed fund. Prices, after all, capture information. The best stocks end up being more expensive than those with worse prospects. The expected return is that of the market as a whole. Bargains can’t be identified in advance. Turns out the best strategy is to avoid the fees and tax consequences of managed funds and take the return of the market as a whole.

Those who are skeptical of indexed funds (and their skepticism is often self-interested) like to point out that one fund, Legg Mason Value Trust, has outperformed the S&P 500-stock index every year for the last 13 years. The indexers respond that with over 6,000 actively managed funds, surely some will outperform their benchmarks purely by chance. But because you can’t know in advance which funds will be the lucky ones, you’re still better off investing in indexed funds.

FOLLOWING A HUNCH. Thirteen years in a row—could it be pure luck? How can it be anything else? Right now, Amazon ( AMZN ) is Value Trust’s single largest holding, almost 10%. Do you think fund manager Bill Miller knows something about Amazon that no one else knows? I doubt it. He’s simply following a hunch the same way some bettors choose black in roulette or use their birth date for picking lottery numbers.

So the next time you’re tempted to identify the hot manager in the hot sector, remember the humble but plentiful bagel. Rely on the wonders of the marketplace. You’re likely to make more money, and you’ll free the time you would spend picking the right fund for more rewarding pursuits that don’t involve your wealth.