Don't Try to Beat the Market

Investing in the stock market is for everyone -- but picking stocks isn't.

Warning: We're going to be blunt
Don't try to beat the market if you have neither the time nor the interest to pursue the reading, research, and judgment that stock and fund investing requires. If this type of work doesn't sound appealing, simply buy the Vanguard 500 Index (VFINX) or another low-cost option, and sleep easy at night.

Robert Hagstrom, author of The Warren Buffett Way, summed it up beautifully:

Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.

The market, in short, is sometimes not logical. Sometimes it's not fair. Sometimes it's downright harsh. It can drive even the most levelheaded of folks mad.

Ready for the good news?
Fortunately, it's entirely possible to be a hands-off investor and still put the long-term wealth-building power of the stock market to work for you. The secret? Index funds.

"The introduction of the First Index Investment Trust [what is now the Vanguard 500 Index] was one of the few truly seminal dates in the mutual fund industry," said Vanguard chairman and CEO John Brennan. Now, admittedly, Brennan may be a biased judge of indexed mutual funds, but we absolutely agree with his assessment. They democratized the stock market in an unprecedented way.

But in addition to giving every individual the opportunity to make money in the stock market, indexes had another very interesting effect: They gave "the pros" -- that is, active mutual fund managers -- some competition. Many haven't answered the call. Some 75% of fund managers fail to beat the S&P 500 on an annual basis. Get this: When VFINX was introduced in 1976, it was one of 360 stock mutual funds. Today, 149 of those funds no longer exist.

And yet ...
Today, there are more active mutual funds than ever. Why? For one, the actively managed mutual fund business is lucrative. More than 90 million Americans invest in the stock market via mutual funds, and mutual funds currently manage approximately $11 trillion worth of assets. Since the average mutual fund expense ratio, according to the Investment Company Institute, is 1.07%, fund companies are pulling in some $117 billion per year simply in fees. Yes, $117 billion!

And why do investors continue to buy into these investment vehicles when 75% of them fail to beat the index? It's human nature. We investors like to view the index as we view any other benchmark -- as something to beat. It's like par at a golf course. And hope springs eternal -- even while the S&P 500 has proved nearly impossible to beat on a consistent basis.

Honestly, the S&P 500 takes on all comers. Major components of the index are some of the best-known businesses in the world, both old-economy and new-economy. Take a look at just a few.

So don't try to beat the market if you're not ready for the commitment and at least some disappointment. Instead, index.

That warning aside ...
If you're still with us, that probably means you're ready to beat the market. Indexing and beating the market aren't mutually exclusive, of course, but to outperform, you need a portfolio of carefully chosen stocks.

Ready for our secret?

One way to whomp the market
First, remember that the S&P is made up of 500 of the market's largest companies, and it's weighted toward the largest of the large. In other words, the performance of the S&P 500 closely tracks that of the market's giants. So if you are serious about beating the S&P, you cannot invest solely in large caps.

Next, remember that one of the best ways to earn great returns is to profit from pricing inefficiencies -- as the aforementioned Warren Buffett has proved time and time again. These pricing inefficiencies tend not to exist among larger companies because many professional investors track them.

Finally, recall that large caps do not offer the market's best returns. No, that honor falls to a very different asset class -- small caps.

So, if you want to beat the S&P 500, you have to differentiate yourself from it, and that means making small caps a significant part of your portfolio.

If you take only one thing with you from reading this article ...
Either commit to investing, or commit to indexing. And if you're ready to commit to small-cap investment, Fool co-founder Tom Gardner's Motley Fool Hidden Gems small-cap service has a cheat sheet of more than 50 handpicked investment ideas.

He and his team are devoted to finding the market's best small caps -- and their picks, incidentally, are beating the S&P 500, to the tune of 33 percentage points since inception in 2003. You can access all our research -- and our scorecard of small-cap recommendations -- free for 30 days. Come and check out the service, read up on our favorite small companies, and do so with no obligation to subscribe by following this link.

This article was originally published on Nov. 6, 2006. It has been updated.

Tim Hanson owns shares of 3M. Brian Richards owns shares of 3M and the Vanguard 500 Index Fund. Tim and Brian promise that their long-delayed comeback album, Laotian Feudalism, will finally be released this year. 3M is an Inside Value pick. The Fool's disclosure policy wants you to know this.