To invest in the stock market, you have two options: actively invest or passively invest.
Active investing involves buying and selling individual stocks in an attempt to beat the market. Or more commonly this means paying a mutual fund to actively invest your money for you. Passive investing involves buying an index fund that holds all the stocks available in the market and holding this fund for a long time.
To someone who is unfamiliar with the stock market, they might think active investing sounds like a better idea – why buy an index fund when you can simply pick individual stocks you’re confident will outperform the market?
But it has been shown that very few actively managed funds are able to outperform the market. In fact, simply buying an index fund that tracks the entire stock market will almost always outperform an actively managed fund in the long term.
A great example of this is when Warren Buffett famously made a bet ten years ago that a S&P 500 index fund would outperform any actively managed fund over a 10-year period. Over the course of the 10 years, the S&P 500 index fund easily crushed all other actively managed funds in the competition, further proving the point that passive investing is superior to active investing over the long term.
But what makes it so difficult to outperform a passive index fund?
The answer to this comes from a fascinating discovery made in a 2014 paper by J.P. Morgan which revealed that the majority of investing returns actually come from a small group of stocks in the market. Researchers went all the way back to 1980 and looked at stock returns for all stocks that have been in the Russell 3000 (an index that tracks the entire stock market) and compared them to the market average:
Two thirds of all stocks under-performed the market average during this time period, while a select few “extreme winners” (about 7% of stocks) beat the average return by more than two standard deviations.
This illustrates an important point: Most actively managed funds were highly unlikely to pick only the extreme winners, but an index fund would have held all these extreme winners simply because it holds all the stocks in the market. This helps explain why index funds have a tendency to outperform. They will always have the extreme winners in their portfolio, while very few of the actively managed funds will.
Consider this simple example to illustrate why index funds outperform most actively managed funds:
Suppose there are only five stocks in the universe. Based on the study I mentioned earlier, we know that most of these stocks will under-perform compared to the market average, while a small minority will turn out to be “extreme winners”.
Suppose four of the stocks (we’ll call them stocks A, B, C, and D) have a 1 year return of 10% while the fifth stock (stock E) is the extreme winner with a return of 50%. Next, we consider all the possible one stock and two stock portfolios that could be made based on these five stocks and their corresponding 1 year return:
The last portfolio containing all five stocks represents the index fund, which holds all the stocks in the market. All the other portfolios represent the actively managed funds, which attempt to pick a smaller group of individual stocks from the entire market. The 1 year return is just the average of the stock returns in the portfolio.
We can see that the index fund beats 10 out of the 15 actively managed funds. Here’s a graph of the one year returns for each fund:
Two thirds of the actively managed funds were beat by the index fund, which confirms the findings of the research study by J.P. Morgan: since only a small group of stocks account for most investing returns, very few actively managed funds are likely to pick these stocks.
In our example, our index fund held the extreme winner stock E, but most of the actively managed funds did not. Simply having this one stock allowed the index fund to outperform two-thirds of all the funds. This is the beauty of index fund investing – you don’t need to spend hours researching to find the next Netflix. When you hold all possible stocks in the market you’re guaranteed to own Netflix.
Of course it’s possible for actively managed funds to beat the returns of an index fund over the course of one year, but the odds are not in their favor. Picking the “extreme winners” is extremely difficult even for the “professionals”.
If you’re still not convinced that index fund investing is superior, consider the fact that there are far more fees and expenses associated with active investing:
- Each time you buy and sell a stock, you pay a trading fee
- Each time you sell a stock for a profit, you pay a capital gains tax
- If you invest in an actively managed fund, you pay a much higher management fee
This means even if you do find an actively managed fund that can match the returns of an index fund, you’ll still lose because of all the fees and expenses.
If you’re looking to be a savvy investor, keep things simple. Investing in index funds will allow you to beat most actively managed funds.
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Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite place to find new personal finance articles to read is Collecting Wisdom, a site that collects the best personal finance articles floating around the web on a daily basis.
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