Though it's made to seem like an extremely complex undertaking, investing in the stock market doesn't have to be difficult. The best course of action is to buy high-quality businesses trading at reasonable valuations with the intention of owning them for the long haul. Compounding can then work its magic.
But this supposed simplicity hasn't resulted in strong returns from professionals. In the last 10 years, a jaw-dropping 93% of active equity fund managers have actually underperformed the S&P 500. This means that investors in these funds are paying to lose to the broad market. That's just ridiculous.
All isn't lost, however. The average investor can follow one extraordinarily easy path to beat these pros. Let's take a closer look.
Index investing
Individual investors would do much better in the market by just buying an index fund. Good options are the Fidelity 500 Index Fund or the Schwab S&P 500 Index Fund. They provide low-cost exposure to the S&P 500, an index that includes the 500 largest companies by market cap in the U.S. In the past, it has averaged a 10% annualized return (with dividends reinvested). This means that a $10,000 investment made 30 years ago would be worth $182,000 today.
This strategy looks even more impressive if you were to dollar-cost average (DCA) on a monthly basis into an index fund that tracks the S&P 500. If you invest $1,000 each month with a DCA approach and assume a 10% annual return, then after 30 years, your portfolio's value would be over $2 million. Only $360,000 of that would come from your direct contributions. It's hard to argue with these numbers, and even Warren Buffett agrees with this strategy.
Besides helping you reach your personal financial goals, the added benefit is that index investing completely eliminates the need to make complex decisions, like what individual stocks to buy and sell, how to properly allocate capital based on target weights, and when to trim or add to a position. The simplicity -- what I think is a necessary ingredient for long-term financial success -- is actually a key feature.
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Poor performance
Consistently investing in a low-cost index fund that tracks the S&P 500 can result in the creation of generational wealth over many decades. It doesn't need to be any more complicated than that. Moreover, this course of action likely ensures that individuals can outperform the vast majority of professionals. That said, I think it's worth looking at some potential reasons for why these experts have such a poor track record.
An obvious issue is that the fees fund managers charge eat away at the gains, so clients end up with lower returns. A solution to this problem would be that managers only get compensated if they beat the market in any given year, instead of collecting a constant management fee regardless of the fund's performance.
The typical mutual fund owns more than 100 different stocks. Why so many holdings? Many funds likely do this because their ultimate goal is to actually reduce volatility and make the journey smoother, not just maximize returns.
Another way to think about this is to ask why a fund manager would think it's reasonable to put money into their 100th-best idea, as opposed to the top idea that's probably already in the portfolio. This doesn't make sense.
Professionals might also put up weak returns because they're not really thinking independently. It's incredibly easy in this industry to just copy others' portfolios, buying and selling stocks without putting much thought into these decisions. An added consequence of this is that it could result in fund managers trading too frequently, which has been shown to reduce returns.
All of this information helps hammer home the point that for the average investor out there looking to build long-term wealth, it's hard to argue with the merits of index investing.
