Who Should Index and Who Should Attempt to Beat the Market

The Motley Fool just published a list of the best stock returns of the last decade. They include blowout successes like Monster Beverage (NASDAQ: MNST  ) , up nearly 20,000%, and Priceline.com (NASDAQ: PCLN  ) , up 6,600%.

These are the kind of stories that make stock-picking so attractive. Many investors can -- and should -- attempt to pick winning companies and outperform the broader market.

But it's not for everyone. Investing isn't easy. We know the vast majority of professional money managers underperform a basic index fund that tracks the S&P 500 (SNPINDEX: ^GSPC  ) . Emotions often send investors astray. Industries change. Sometimes you just get it wrong. For those who don't have the time or predisposition to be a good stock-picker, investing in a basic index fund is a great alternative.

So, who should index and who should pick stocks? Two weeks ago, I asked Robert Arnott, CEO of Research Affiliates and one of the smartest minds in modern finance. Here's what he had to say (transcript follows).

Morgan Housel: Who should index, and who should try to beat the market through stock picking?

Robert Arnott: That's an interesting question. It depends on an investor's objectives. It's fun to study companies and to try to second guess Wall Street. It's also not necessarily all that hard because Wall Street is now so obsessed with short-termism that long-term value doesn't matter to the decisions of vast throngs of institutional investors. The key question is: Is this stock going to go higher later today if you're a high frequency trader, later this year if you're a mutual fund investor? It's not a matter of: Is this company going to be worth more in 10 years?

And so I think retail investors -- if they're rational, careful, thoughtful -- can go through the process of looking at profits, looking at a company's business and asking the question: Which companies are going to do well over the next 10 years, and can actually do reasonably well?

The challenge for retail investors, as for institutional investors, is emotion. Emotion encourages us to do what's comfortable; the markets do not reward what's comfortable. Imagine buying Citi when it briefly dipped below a buck a share in early '09. Terrifying, this stock's headed for zero. Well, it could have gone to zero. Or it could have gone up tenfold and then some.

The asymmetry is what creates the opportunity. Emotion will discourage us from doing what's feared and loathed in the market, and that's where the biggest opportunities are. So since most people are emotional, I would say most people should index, and that doesn't mean cap weighting.

Morgan Housel: Of course with indexing, you can still be emotional and buy high, sell low.

Robert Arnott: That's if people trade indexes. If people trade indexes, buy in, the market's on a roll, you feel you've missed a ton of opportunity. Gosh, I want to get on this bandwagon before its ride is over; that's human emotion again. And so a disciplined rebalancing process where you engage in broad diversification, U.S., international, emerging markets, not equity-centric; rely on stocks for part of your portfolio. Rely on bonds, U.S., high yield, international, emerging markets. Rely on alternatives, commodities, REITs, these kinds of things.

If you engage in a disciplined rebalancing approach and whatever has been spectacularly successful over the last two or three years, trim it. Whatever's been spectacularly disappointing, buy back into it. You can do very, very well, but most people lack the discipline to do that kind of cool, collected contra-trading because it's wildly uncomfortable.

Recently, I've been using Apple versus B of A as an interesting example. Apple's beloved; everybody loves it. Everybody wants it in their portfolio. Practically everybody has it in their portfolio, and B of A is a much bigger company trading at much lower market cap. So is B of A going to be a more successful business than Apple? Highly doubtful. But you're already prepaying for that success in Apple's price. You're already prediscounting for disappointments in B of A, so I'd much rather own B of A than Apple.

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