Actively managed mutual funds have generally underperformed broader market benchmarks. In 2022, exactly 50% of all domestic funds underperformed the S&P 500 index. But in 2021, when the index gained 29%, 80% of funds underperformed.
That could lead investors to believe it makes the most sense to just invest all of their money in an index fund. But while it certainly does make sense to have some of your money in an index fund, there is reason to think you can do better than many actively managed funds and increase your ability to beat the market.
Why do so many funds underperform?
Why is it so hard to beat the market? Or is it so hard? Consider how large-cap fund managers have performed versus the S&P 500 over the past 20 years:
Image source: S&P Global.
You would think that if you had all the power to pick whatever stocks you wanted for a portfolio, you would have a decent chance of beating the market. After all, "the market" (which could mean different things) includes every stock -- those that gain, and those that lose.
But if, when you say "the market," you're referring to the S&P 500, then you're competing against a select group of industry leaders. That sounds harder to beat, but you can choose the best of those, as well. You also have the opportunity to choose up-and-comers that aren't industry leaders yet, but have mammoth growth potential.
Peter Lynch is celebrated as one of the top mutual fund managers during his time running Fidelity's Magellan mutual fund, when he consistently beat the market. He explains in his popular book, One Up on Wall Street, that many fund managers are hampered by various rules and regulations related to their companies, their specific funds, or other managers they answer to -- such as for companies that outsource their pension-fund managing.
Within each of these groups, there are specific directions for how to invest. For example, a small-cap growth fund only invests in (as you guessed) high-growth stocks with low market caps. Within that group, managers might be pressured to choose the ones with the highest sales growth, so directors can send an annual shareholder letter proving they're choosing the highest-growth stocks.
However, those choices might by default include companies with soaring losses or other risk factors that can make their stock prices plummet.
So it's not as if mutual fund managers as a class are just poor stock pickers. Many of them might have exceptional individual portfolios but be forced to underperform for their clients due to restrictions in the investment policy of that particular fund. Lynch himself didn't have these pressures.
How you can do better
As an individual, you might have thought that if the pros can't do it, how can you? Now you might see what advantages you have when choosing your own portfolio.
Today, there are so many resources available to help retail investors become the best investors they can be, and even beat the market. There's no need to put your confidence in a broker or a fund manager, although many investors might feel more comfortable doing that, and that's OK.
There are 8,000 stocks listed on U.S. exchanges. That could be overload when you consider all of them. Thinking about companies you use and like is a great first step to finding stocks that could be big gainers. Digging deeper for a full analysis -- including assessments of management, potential, risks, and more -- will help you clarify whether a certain stock has the ability to become outstanding over time, or even beat the market.
Why you need a diversified portfolio
Since it's so hard to beat the market, it makes sense to put some of your money into an index fund. That way, you can benefit from the overall gains in the market but also give yourself the opportunity to make the rest of your holdings work harder for you.
Most people benefit from having a varied portfolio of about 25 to 30 stocks in different industries that each bring something to the table. Small and large, growth and value, and dividend payers are some of the major categories of stocks.
If you do your research and set up a fairly diversified portfolio across industries and stock types, you'll have more than a solid chance of beating the market over time. At the very least, you can outperform the pros and enjoy the long-term gains of investing.
