The Only Way to Beat the Market

Should investors buy individual stocks or stick to passive index funds? This was the question addressed by my colleague Morgan Housel in a column published earlier today.

He concluded that you should only invest actively -- that is to say, via individual stocks -- if you have an "edge at stock picking." He went on to note that essentially the only advantage individual investors have over the pros, if you will, is time -- he went into further detail about this idea here.

These are critical observations that all investors, particularly those who think they can beat the market, would be well advised to heed.

I say this because, to dovetail off Morgan's more general point, individual investors are, by and large, very bad at investing. Take a look at the following chart.

This compares the 20-year returns of the average mutual fund investor to the S&P 500 (SNPINDEX: ^GSPC  ) . Over the two decades directly preceding 2003, for instance, the broader market advanced at a compound annual growth rate of 12.98%. The average mutual fund investor, meanwhile, achieved an analogous return of only 3.51%.

And the story is the same for every single year analyzed by the DALBAR study. Every single year!

At first, I didn't believe it, so as an experiment, I went back and looked at two of my own more profitable investments in individual stocks over the last few years. Guess what I found?

In October of 2010, I purchased shares of Bank of America (NYSE: BAC  ) that are now up 17%. By comparison, the S&P 500 has advanced by 45% over the same time period. And at the end of last year, I went long on shares of Intel (NASDAQ: INTC  ) , which, excluding dividends, are now higher by 14.5%. The S&P 500, meanwhile, has gained 22%.

My performance aside, what's behind this trend? According to DALBAR, "Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market."

So what's an investor to do? To note a slight nuance in Morgan's conversation, the underlying choice in investment strategy isn't only between passive index funds and individual stocks, as both can be bought and sold at inopportune moments. The biggest edge in both, in other words, is time -- a notion I believe he would agree with.

This was directly addressed by the authors of the DALBAR study as well (emphasis added):

Correcting the folly of market timing can be approached in one of two ways. The first is to guess correctly instead of incorrectly. This approach is unrealistic and clearly does nothing to alleviate the market timing problem, in fact it only serves to reinforce it. A second way to avoid market timing pitfalls is to not time the market but instead adopt a buy and hold strategy that has rewarded prudent and patient investors for decades.

Thus, to conclude, buy and hold is not only alive and well, it is almost certainly the only game in town for investors looking for optimal performance.

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