According to Bill Schultheis, author of The Coffee House Investor, active managers constantly and consistently underperform the stock market average for two main reasons:
First, the stock market average is already very efficient. In a broad sense, the market does reliably well. The better it performs, finding ways to “beat” it proves more challenging to near impossible.
Second, your “managed” investment will suffer from substantial annual expenses, which, of course, reduce your total return.
Since the stock market average has historically provided an already-exceptional investment return, odds are that when you try to beat it, you will fall below it. And what a shame that is to the investor who could have easily spent far less, both financially and mentally, to return the relatively superior stock market average.
What’s the solution? A passive investment approach that aims for the stock market average by using unmanaged index funds.
A stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index. Instead of stock-picking, you invest in every stock. By doing so, investors are able to most reliably secure the approximate stock market average in their returns. There’s no need for management (besides passive quarterly inspection/infrequent rebalancing according to preferred asset allocation), because a piece of every stock is purchased. This eliminates the burden of active stock-picking or hiring a “professional” to do so—and consequently enhances your quality of life significantly.
Moral of the story? History shows that investing in the creativity of all human beings equally is actually more profitable, on average, then investing with a mutual fund manager who promises to beat the stock market by selecting the “best” companies to invest in. It also happens to be simpler, less time-consuming and stress-inducing, and much cheaper to do so by means of low-cost, unmanaged stock index funds.
As a final note, consider Pascal’s Wager and its wisdom here; would you rather invest in the entire market to secure a comfortable return that beats most mutual fund managers, foregoing great returns accompanied by great risk, or invest selectively with “professionals”, aiming for great returns, yet most likely falling short of the average? The choice is yours.
- Active managers constantly underperform the stock market average return because the stock market is already very efficient and their fees and expenses reduce your total return.
- Low-cost, passive index funds are the easiest and most cost-effective vehicles for returning the stock market average
- A stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index, thereby approximating the stock market average in its return
- These index funds are “passively managed” because, besides infrequent monitoring and annual rebalancing according to preferred asset allocation, investors never have to manage these funds.
Munir Gomaa is a 3rd year dental student with a passion for personal finance, self-improvement, and human psychology. He can also be found blogging at munirgomaa.com
Click here for related post, “Understanding the Market.”