The 14 Truths You Must Know When You Invest

Collectively, you and I get the same return as John Bogle, who decided to simply build an index of the two stocks. However, on a net basis, he has to have higher returns because he has no middleman to pay -- he pays no broker fees, no trading costs; he only pays a very modest expense ratio. What this simple exercise proves -- and Bogle has written on this, co-opting some of William Sharpe's work -- is that all investors, on a gross basis, must get the same return.

If the market goes up 15%, passive investors owning Vanguard's Total Market index fund of a total market exchange-traded fund get 15%. If you invested in the S&P 500 over past 75 years, you got 10%. It's a zero-sum game. But active investing is not a zero-sum game. It is a negative-sum game -- just like gambling. Net, we end up negative, because the bookies take their cut. The bookies -- market-makers, commissions, etc. -- collectively, they make it certain that active investing must be a loser's game. Active investors must underperform.

Now, if you change the plus-15% return to a minus-15% return, what does that do to the average of all investor returns? Nothing; they still end up getting minus 15% on average. That shows one of the great myths to be a lie -- that active investors do better than passive investors in a down market.

Active investing clearly doesn't work among large-cap stocks -- because the market is so efficient among large-cap stocks that you can't exploit any new information. Anyone who says that active investing works in large-cap stocks should wear a big shirt that says either "I cannot add," or, "I'm lying." There are only two explanations.

Substitute large-cap stocks for emerging-market stocks or small-caps stocks, and active investing still doesn't work -- even though there may be some operational inefficiencies to exploit. Here's the reason that's true. I'm not saying information efficiency doesn't exist. It comes down to costs: The more efficient the market is, the less it costs. In the small, less-efficient information market -- small-cap stocks -- it's possible you'll find something other people don't know. But the bid-offer spreads are wider; the costs of obtaining the information are greater. In emerging markets, where there's probably some information advantage, you pay a lot to get that advantage, and the higher costs essentially offset the advantage.