Index fund investing can offer good results for two reasons. Low costs can save you hundreds of thousands over the long term and index funds tend to perform better than actively managed funds over the long term. Better performance at a lower price. What’s not to love?
The argument I often hear from high cost mutual fund supporters are that “index funds are just average”. “If you want to be better than average you need to pick stocks within the index”. “Index funds are boring”.
It sounds great on the surface. I mean, who doesn’t want to be better than average? Here’s the kicker though – index funds are better than average. Yes, they may be the average of all companies in the index, BUT the results of the index are generally better than that of individual stock pickers over the long term. Countless studies have shown this.
In any given year, plenty of people can pick companies that will outperform the market. Over two years, fewer people will be able to outperform the index. Five years, and even fewer people can outperform the index. Extend this out to 20 years plus, and most people who pick individual stocks have performed worse than the index. Each year that passes, more and more people get overtaken by the index.
4 reasons why it is so difficult to beat the index
1/. Companies don’t perform how we expect them to.
Some make poor decisions. Some have leaders that weren’t who we thought they were. Some fudge their books. Some experience a recession or bankruptcy and leave the market. A well regarded leader such as Jeff Bezos may unexpectedly resign, bringing down the company stock value. Some are affected by regulatory decisions such as a bank affected by a change in lending criteria. Some are affected by political decisions such as a tourism company affected by a governmental decision to reduce the number of migrants.
The point is, things happen that we cannot predict no matter how hard we study a company. To pick well for many years requires these things outside of our control to consistently go our way which is very rare.
2/. Our own behaviours can be poor.
It is human instinct to always want the best stocks. This means buying the current hot stocks which means they are already highly priced. It is best to buy stocks before they get hot. By always chasing the best, we are buying over priced stocks and not getting the best returns.
Active investors buy and sell more frequently than passive investors. This not only means higher costs, but it also allows more of an opportunity for our bad behaviours and habits to manifest, because we are making more decisions. Bad decisions or poor timing can cost us thousands.
3/. The index is diversified
By investing in every company in the index, you are investing in companies of all shapes and sizes, from different regions, in different industries and different stages of growth. If one company goes bankrupt in an index of 100 companies, the effect is not that noticeable. However, if you are stock picking and have a portfolio of 20 companies where one goes bankrupt, the losses are much more significant.
It is much more difficult to build a well diversified portfolio when you aren’t tracking the index. This is because you simply own less companies. In any given year, it tends to be only a few stocks that perform exceptionally well which drags the index value up. Conversely, only a few companies tend to perform exceptionally poorly dragging the value of the index down.Trying to pick a few companies out of hundreds is no easy feat. In fact, most would say it is more luck than anything.
Whereas, an index fund will hold all those winning stocks guaranteed. Yes, they will also have the losing stocks, but so too could the active investor. Where the passive index investors winners are guaranteed, avoiding the losers and having the winners for the active investor are not.
Active trading incurs higher fees than passive index investing. Just a small percentage difference in fees can have a huge difference over the long run.
If investor A is an active investor and invests $10,000 a year for 30 years with fees of 1% and average returns of 7%, they will end up with $841,000
Investor B is a passive investor and invests the same amounts as investor A. Same returns. The only difference is their passive investing fees are 0.4%. They will end up with $945,000.
Over $100,000 more in the hand from just a 0.6% difference in fees.
Even if an active investor, after everything else, can beat the returns of a passive index, after the difference in fees has been deducted, it becomes more unlikely.
What matters is returns you get in your hand. Not returns before fees.
Sure, there will be a small percentage of people that do better than the index over the long term. No offence, but the chances of you being one of those people is slim to none. Maybe over the short term, but not 20 plus years.
Low cost index investing could not be easier, so if you are scared to enter the market this is a great start. Some active investors may try to make you feel bad by saying things like “index investing is only for beginners”, or “index investing are only average returns”. The fact is, index investing is not just for beginners and the returns are clearly better than average. Even many active managers now use index investing, so be careful you are not paying a professional to do something that you can easily do yourself at a much lower cost.
It appears the pros have decided, if you can’t beat ‘em, join ‘em.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.