I just finished watching my first episode of Deal or No Deal, a new game show on NBC. I personally thought it was amazingly dull, but it did remind me of a good parallel to investing that I read in the book The Coffeehouse Investor (Yes, I know. Who’s the dull one?). If you’ve never seen it, that’s okay, this is a simplified version which I will explain. (You can also play an online version if you’d like.)
Let’s say you have ten open suitcases, each with a different amount of money in them:
Obviously, if you had a choice you’d pick the one with $10,000 in it. But the Banker then closes the suitcases and mixes them all up. Next, he reveals the $8,000 suitcase. You can still choose any of the suitcases to take home. Which one would you pick?
Added: It’s interactive now! Click on a suitcase if you want to gamble.
This is similar to the situation that you are faced with when picking an active vs. passive mutual fund. Over extended periods, approximately 75-85% of actively managed mutual funds fail to match the total market average. Yes, you could pick the $9,000 or $10,000 suitcase, but do you want to take that risk? We should all the take $8,000 happily.
Knowing the $8,000 suitcase is readily available is another analogy to knowing about index funds. Otherwise, you might be walking around with the $6,000 or $7,000 suitcase thinking you got lucky… Remember, even picking the active mutual funds with the best 10-year historical returns doesn’t work! For example, the top 35 mutual funds from 1978 to 1987 cumulatively under-performed the stock market average by 7 percent annually the next ten years (data also taken from The Coffeehouse Investor.)