Index funds track indices such as the S&P 500 and match the market not try to beat the market.  They are cheap to manage – I guess all you need is a computer program and you don’t need to pay expensive managers.  An individual investor who does not have inside information will lose relative to the market and an index fund provides the best way to guarantee at market returns.

So, people buying index funds should have that kind of philosophy.  This philosophy also means that you cannot beat the market on day-to-day or hourly transactions – any news you are responding to will also be incorporated in the index fund value and all you will do is incur the transaction cost of buying or selling.  So, people who buy index funds should buy and hold.  Unless they have a self-control problem.   Then, they will respond to price movements despite knowing they cannot make money on average.

Investors who face self-control problems face more difficulties if they buy an index fund in the form of an ETF and not a regular mutual fund.  The former are continuously traded and the latter only allow you to buy and sell at the end of the business day.  Hence, the latter allow you to commit not to indulge your self-control problem.

First, ETFs are cheaper than the corresponding mutual fund so the first puzzle is why mutual funds are not driven out my ETFs.  This is one answer: there is demand for mutual funds from people with self-control problems and in fact they are willing to pay to commit.  There is a value to commitment.

Second, investors who think they cannot beat the market but believe they have self-control should buy ETFs.  If their belief in their self-control is naïve, they will trade anyway and get worse returns than investors who bought mutual funds.  Via the NYT:

“An analysis of the numbers by Kevin P. Laughlin of the Bogle Financial Markets Research Center, found that in the five years through October, what investors earned from their holdings in E.T.F.’s trailed the returns of the funds themselves by 3 percentage points, annualized. By comparison, the earnings of investors in traditional mutual funds lagged their funds’ returns by 1.1 percentage points. These lags happened because investors were buying and selling at the wrong times.”

There is a value to commitment but there is also a value to self-knowledge: recognizing your self-control helps you to know that you should commit and if you commit, you will lose less money.

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