DEAL OR NO DEAL ...

While working out this morning, I was reading a book addressing a commonly debated issue in the world of investing - is it better to take the boring, 'average' returns of the market (i.e., index investing) or should one take the much more exciting route of attempting to beat the market (active investing). The Peter Lynch and Warren Buffetts of the world make the argument for active investing very compelling (because you would have done much better having your money invested with them as opposed to the general returns the stock market would have yielded). In the book "The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on With Your Life," author Bill Schultheis describes a game called "Outfox the Box" in which a Howie Mandel-type "Deal or No Deal" question is asked. The author makes an interesting argument for index investing. The game goes like this:

You visit a local investment firm and ask them to invest $10,000 for your benefit and give them full discretion to make investment decisions on your behalf [which they do]. Ten years later, you go back and ask for the money. You are led into a room and shown 10 boxes arranged on a table. Each box has money inside. You are given a list showing the amount of money contained in each box. The list looks like this: #1 - $16,000, #2 - $17,000, #3 - $18,000, #4 - $20,000, #5 - $22,000, #6 - $23,000, #7 - $24,000, #8 - $25,000, #9 - $26,000, #10 - $30,000. You are then asked to leave the room. After about five minutes, you are allowed to come back in the room. The ten boxes are still on the table, but this time only box 8 (with $25,000) is open. The other nine boxes are closed, and the box numbers are all covered [the order of boxes on the table has also been changed]. The representative from the firm tells you that none of the money in the boxes has been touched and goes on to ask, 'without opening or touching the boxes, you may choose one box as your investment return, including box #8 ($25,000). Which box do you choose?'

Interesting quandry ... do you take the $25,000? Or do you forfeit the known quantity for an unknown with the chances of more ($26,000 or $30,000)? This 'attempt' to do better is what active investing is all about. Answering the question mathematically would probably provide some clarity ... Ultimately you have a 2 in 9 chance of bettering yourself by picking the box with more money. The average amount in those boxes is $28,000. That is a 22% probability of gaining an extra $3,000. Conversely, there is a 7 in 9 chance of picking a box with less money in it. The average amount in those boxes is only $20,000. That is a 78% probability of earning $5,000 less than the guaranteed $25,000.

If you had been faced with this decision, what would you choose? If you picked the $25,000 box, you are a perfect candidate for the world of index investing ... it's not exciting, you'll never wind up with above average returns. History has shown, however, that the odds of beating "the market" on a consistent basis is not stacked in your favor. I'll share some more resources next week about this ...