Here is a question that has haunted investors for many decades: Should you pick certain stocks yourself in hopes of outperforming the market, or should you just not bother with all the research and headaches and simply invest in an index fund or exchange-traded fund?
Picking stocks can be an exciting endeavor for investors who like to dig through hundreds of pages of annual reports and disclosure filings, and who enjoy doing the calculations themselves. However, investors can also select "passive" investment strategies like those noted above.
An index fund basically tries to replicate the performance of an underlying stock market index, such as the S&P 500. However, it will naturally underperform the index because of transaction costs and other fund-related expenses.
The case for passive investing
Despite an additional cost layer, passive or index strategies can make a heck of a lot of sense. Research has shown that even investment professionals such as active fund managers (those who engage in stock picking in order to deliver value for fund holders) with many years of investing and market experience don't do that well over long performance measurement periods.
The following chart shows that barely the majority of active fund managers can beat the market performance during most bull and bear markets.
So if professional money managers can't do the job, what else is there?
You really have only two choices: do it yourself and assume you will be better than fund managers or use an index approach, such as an index fund or an exchange-traded fund.
If you think you can invest better than other managers,consider this chart to see how the average investor did over a two-decade timespan.
Many investors seem to see themselves in an extremely good light, but the results certainly indicate that the average investor should not pick his or her stocks.
It is also noteworthy to point out, that the S&P 500 index achieved an annual return almost 3.7 times higher than the return achieved by the average investors: 7.8% vs. 2.1%.
If fund managers and the average investor are not up to the task, a passive investment approach might appear to be an interesting and viable investment alternative.
This strategy enables you to use a low-cost index fund and ETF, which usually have low expense ratios.
Furthermore, passive investing provides you with broad market exposure and a high degree of diversification. By investing in an exchange-traded fund that tracks the performance of the S&P 500, for example, you gain broad diversification at a relatively low cost.
Also, ETFs are listed on a stock exchange and can be traded just like any other security, providing investors with the crucial benefits of transparency, price discovery, and liquidity.
If you need yet another reason to give up stock picking, just consider that even superinvestor Warren Buffett endorses passive investment strategies. In his latest shareholder letter, Buffett suggested that readers "put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund."
If Buffett believes in indexing, maybe you should, too.
The Foolish takeaway
Professional and amateur investors alike clearly have problems outperforming their benchmark indices -- at least over long time periods.
Valid alternatives to active management, therefore, are passive investment strategies that use low-cost exchange-traded funds, which provide high liquidity, or index funds, which often have the lowest expense ratios of all alternatives.
Another benefit of investing in index products is that investors won't have to bother with all the research and stress that come with investing in certain securities. They also receive a high degree of diversification, which can provide crucial protection during market downturns.
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