Is it better to pick stocks, or should investors stick to index funds? The debate between active and passive investing stretches back many decades: Traders and hedge fund managers have argued that smart stock picking can outperform the market; others -- often academics -- have maintained that, in the long run, the market is fairly efficient, and nearly impossible to beat.
Peter Thiel belongs in that first category. In his new book, Zero to One, Thiel urges entrepreneurs and investors to take a proactive approach. In a recent phone interview, the venture capitalist and hedge fund manager told me why investors should be weary of blindly putting their wealth in the hands of the market.
Think for yourself
The case for index funds is fairly straightforward: While a few stock pickers manage to post stellar results year after year, the overwhelming majority fail to beat the market. It's an imperfect measure -- it doesn't take into effect risk-adjusted returns -- but for the last five years, hedge funds (in aggregate) have underperformed the S&P 500 index (SNPINDEX:^GSPC).
But even if many lose money, Thiel believes investors are still better off making their own decisions. By putting money in an index fund, rather than choosing their own portfolio, Thiel argues investors are taking a shortcut -- and failing to think for themselves.
"[Investors have come to believe] that [they] don't need to think for [themselves]. That everything is taken care of by the market in one way or another ... So you should just invest in an index fund because the market knows better ... When you believe that, you stop thinking for yourself ... [You believe that] the market knows everything. There's no point in trying to figure out what a company should be worth -- you can just look up the stock prices. Stock price tells you all the information -- Efficient Market Theory ... We end up not thinking. We've found all these shortcuts to avoid thinking for ourselves. In aggregate, they serve us pretty bad."
Thiel has never been one to settle for index funds. In addition to co-founding PayPal, he was one of the first investors in Facebook -- when the social network went public, his $500,000 investment went on to be worth over $1 billion.
The madness of crowds
Compared to hoarding cash, speculating in real estate, or buying gold, an index fund such as the SPDR Dow Jones Industrial Average (NYSEMKT:DIA) could prove a wise investment. Certainly, over long periods of time, buying the broader market has produced reliable, steady returns -- its hard to argue that index funds are completely worthless.
Over the last 10 years, for example, the DIA has rallied more than 73% -- in spite of the financial crisis, the Dow Jones Industrial Average is near its all-time high; index funds designed to track it are likewise (and unsurprisingly) also near their all-time highs. That's a much better return than even the longest-dated CDs.
But Thiel believes the mind-set index funds endear -- don't worry about it, the market will take care of everything -- is inherently dangerous, and may even contribute to the formation of economic bubbles.
"Obviously, at some point when everyone believes [that the market knows best], you get these enormous distortions; enormous bubbles. One thing that characterized the bubbles of recent decades is that people were not thinking for themselves -- at all. Finance presents itself as a system that's automatic, that everything is taken care of ... That's [a] lie."
Sam Mattera has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.