One popular investment approach is turning your portfolio over to a professional fund manager, whose job is to outperform the broader market over time. This is also known as active investing, and it seems like a smart decision.
You might be surprised to know, however, that 93% of large-cap fund managers lose to the S&P 500 over a 20-year period. That's according to data from S&P Global's latest SPIVA U.S. Scorecard, from the first half of last year. Over three years, it's about 80%. Clients are basically paying to underperform. That sounds crazy, but this is the reality of the investment management industry.
There's good news, though. If your goal is to beat the stock market experts, history proves that there is one ridiculously easy way to do so.
Here's what you need to know.
Simplicity is key
If the vast majority of fund managers lose to the market over an extended period of time, the flip side couldn't be more obvious. Owning an index fund that tracks the S&P 500 -- that is, passive investing -- will almost certainly lead to returns that beat the so-called experts.
Investors have multiple options to choose from. Some of the best S&P 500 index funds are the Fidelity 500 Index Fund, Schwab S&P 500 Index Fund, and Vanguard 500 Index Fund Admiral Shares. They're all offered by reputable firms that have long operating histories. All of these options carry extremely low fees, and they have many billions of dollars in assets each.
Over the past 20 years, the broad index of the largest and most profitable companies in the U.S. has climbed at an annualized rate of 9.6%, a figure that includes dividends. This means a $10,000 investment made in January 2004 would be worth $62,900 today. That's an impressive return.
Investors who are able to consistently add even more savings on a recurring basis can supercharge their gains. For example, if you also invested $100 more each month, in addition to the $10,000 initial outlay I just mentioned, you'd be sitting on a balance of $131,600 today.
There is another clear benefit of investing in an index: This entire investment strategy can be fully automated. And all it requires is the discipline to continue saving, with a long-term mindset. It's all about staying the course. And investors will benefit from simply having more time in the market, which is a method that works.
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Paying for underperformance
Passive investing has an impressive track record. It's a strategy that even Warren Buffett agrees is the best for the vast majority of individuals out there. But this has to make one wonder why fund managers, who are supposed to be professionals in the industry, generally underperform the market.
I think there are a few reasons for this. Fees that active managers charge can eat away into any excess returns that they're able to generate. And so while these pros might be talented stock pickers, their clients don't see the full benefits due to the expenses involved.
Another culprit may be over-diversification. The average mutual fund holds more than 100 different stocks. With that many holdings, they're essentially mimicking the broader index to limit volatility. But if a fund manager really knows what they're doing, they should be concentrating the portfolio into what they believe are the best ideas. That's an approach Buffett himself practices.
Overconfidence might also play a role here. As the name suggests, active managers are constantly adjusting their portfolios, buying or selling positions. But there are studies that show that too much trading negatively impacts returns.
For the average investor who wants to beat the experts, there might be no better way than to go the passive route.
