Investors as a group earn the market minus costs
Why investors together can only earn what the market earns, why every fee and trade comes out of that same pot, and how small yearly costs grow over a lifetime.
FinanceCosts and the marketAbout 7 min: 4 reading, 3 practiceUpdated
General education, not financial advice.
- Explain why investors as a group earn the market return before costs
- Explain why trading among owners can't raise what they earn together
- Show how yearly costs compound over time
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
Money over time: lesson 5 of 5
- Mankiw ch. 14
- Compound interest 5 min
- Present value 5 min
- Mankiw ch. 11
- Measuring inflation with a price index 4 min
- Real and nominal interest rates 3 min
- Costs and the market
- Investors as a group earn the market minus costs 7 min
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Pairs with any account of "the arithmetic of active management", such as William Sharpe's 1991 article of that name, or John Bogle's The Little Book of Common Sense Investing (2007), chapters 1 and 4
What it is
It is simple arithmetic, set out by the economist William Sharpe and by John Bogle, who started the first index mutual fund:
- All investors together own the whole market, so before costs they earn exactly the market's return. For every investor who beats it, another falls behind by the same amount.
- Investors pay costs: management fees, trading costs, sales charges, and the taxes that trading creates. So after costs, investors as a group must earn less than the market, by exactly what they paid.
Bogle's summary: before costs, beating the market is a zero-sum game; after costs, it is a loser's game.
Quick check
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All investors together, before costs, earn…
- For every investor ahead, another is behind by the same amount
Show answer
the market's return. Together they own the whole market.
Why it matters
The Gotrocks family. Bogle opens his book with a parable, his version of one Warren Buffett told in a 2005 letter to Berkshire Hathaway shareholders.
A huge family, the Gotrocks, owns every share of every U.S. company. Each year the family receives everything the companies produce for their owners: all the dividends paid out and all the earnings kept and reinvested. Everyone grows richer at the same pace.
Then the Helpers arrive:
- Brokers persuade some "smart" cousins to trade shares with their relatives, hoping to get a bigger slice. The brokers charge commissions, and the trading creates tax bills.
- When that disappoints, the cousins hire money managers to pick stocks. They charge fees and trade even more.
- When that disappoints too, they hire consultants to pick the managers. More fees.
In Bogle's telling, the family's share of the companies' earnings falls from 100% to 60%. A wise old uncle tells them to get rid of the Helpers and simply hold everything again. Bogle's point: that is exactly what an index fund does.
The story turns a complicated industry into one question: who gets the businesses' earnings? The owners can only share out what the companies produce. Every commission, fee and extra tax comes out of that same pot before the owners see it. Bogle quotes Buffett's moral as a "fourth law of motion": for investors as a whole, returns decrease as motion increases.
And costs are taken every year, whether returns are good or bad, so they compound like interest in reverse. A cost that looks small in one year can take a large share of the gain over a working lifetime.
Quick check
Tap an answer to check it.
When one cousin sells shares to another, what happens to the family's total share of the companies?
- Shares only change hands inside the family
Show answer
It stays the same, minus what the Helpers take. Trading moves ownership around; it doesn't create earnings.
Worked example
The pot. The companies produce 100 for their owners this year.
- No Helpers: the owners keep 100.
- Helpers take 40 in commissions, fees and extra taxes: the owners keep 60, which is Bogle's 60%.
One cousin may now do better than another. But the family as a whole can only share the 60 that is left.
Text description
Bar chart. No helpers: 100%; With all the Helpers: 60%.
Over time. 10,000 grows for 30 years at 6% a year before costs.
- With no costs: 10,000 × 1.06³⁰ ≈ 57,400.
- With costs of 1.5% a year, it grows at about 4.5%: 10,000 × 1.045³⁰ ≈ 37,500.
Costs take about 20,000, roughly 42% of the 47,400 the money would otherwise have gained. (The figures are rounded, and the costs Bogle quoted were from 2007; they have changed since.)
Common mistake
Thinking that because some investors beat others, investors as a group can beat the market. Every gain from a trade is another investor's loss. Only the Helpers are sure to come out ahead.
The second mistake is judging a cost by its size in one year. "1.5% is tiny" ignores that it is charged every year on a growing balance. Always look at what it adds up to over the whole time you will hold something.
Key terms
- market return
- the return of the whole market
- zero-sum
- one side's gain is another side's loss
- index fund
- a fund that simply holds all the shares in a market (or an index), in proportion, and keeps them
- expense ratio
- a fund's yearly running costs, as a % of what you hold
- commission
- a fee paid to a broker for each trade
- Helpers
- Bogle's name for brokers, managers and advisers paid by investors
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| market return | the return of the whole market |
| zero-sum | one side's gain is another side's loss |
| index fund | a fund that simply holds all the shares in a market (or an index), in proportion, and keeps them |
| expense ratio | a fund's yearly running costs, as a % of what you hold |
| commission | a fee paid to a broker for each trade |
| Helpers | Bogle's name for brokers, managers and advisers paid by investors |
Practice
Sort it
Does it add to the owners' total, or only move money between them (or out to the Helpers)?
The companies earn more profit
New earnings make the whole pie bigger.Show answer
Adds to the total. New earnings make the whole pie bigger.
A cousin sells shares to an aunt
Ownership changes hands; the pie is the same.Show answer
Moves money around or out. Ownership changes hands; the pie is the same.
A manager charges a yearly fee
It leaves the family.Show answer
Moves money around or out. It leaves the family.
The companies pay out dividends
Dividends are part of what the businesses produce for owners.Show answer
Adds to the total. Dividends are part of what the businesses produce for owners.
Tax on a gain from a trade
It leaves the family.Show answer
Moves money around or out. It leaves the family.
Quick quiz
Tap an answer to check it.
Why do investors as a group fall behind the market after costs?
- The argument holds whatever the market does
- Inflation affects everyone's real return, not the gap to the market
Show answer
Because the costs are subtracted from the market return. The group gets the market return, minus everything it paid out.
A friend says: "Lots of fund managers beat the market, so if everyone used a good manager, we'd all beat it." What is wrong?
- Picking only moves gains between investors
Show answer
Investors as a group are the market: one investor's lead is another's shortfall, and the managers' fees come out of the total. Before costs the group earns the market return; after costs, less.
What does the uncle's advice in the parable correspond to?
- That is another Helper
Show answer
Holding all the shares and trading as little as possible, like an index fund. Owning everything and standing still keeps the whole pie with the owners.
In short
- Before costs, investors as a group earn the market return; trading among them moves money around but adds nothing.
- After costs, the group must earn less, by exactly what it pays to brokers, managers, advisers and the tax collector.
- Costs come every year and compound, like interest in reverse.
- Judge a cost by what it takes over the whole time you hold something.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
Why can't investors as a group make themselves richer by trading with each other?
Show answer
Each trade only moves shares between investors, and the brokers, managers and taxes take a cut.
Name two kinds of investing cost from the lesson.
Show answer
Any two of: management fees, trading costs, sales charges, taxes from trading.
Why does a yearly cost matter more over 30 years than over 1 year?
Show answer
It is taken every year and compounds, so it reduces each later year's growth as well.
Further reading
- William F. Sharpe, "The Arithmetic of Active Management", Financial Analysts Journal 47, no. 1 (1991).
- John C. Bogle, The Little Book of Common Sense Investing (John Wiley & Sons, 2007), chapters 1 and 4.
- Warren Buffett's letters to Berkshire Hathaway shareholders are free on berkshirehathaway.com; the 2005 letter tells the original story.
- Investor.gov, the U.S. SEC's investor education site, which explains fund fees in plain language.
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