You Should be Index Investing Instead of Picking Stocks

12:16 am · 9 min read

The reasons why actively picking stocks sucks and how index investing can give us a fair chance in the game.

Let’s admit it, we are not very good at picking stocks.

We feel great about the long-term potential of the stock market, but forget that our portfolio allocation has less than 10 stocks.

We fail to notice that owning a few shares of Apple, Facebook, and Bank of America will not produce the same result as the S&P 500 index.

And the worse part is that research confirms our inability to pick stocks.

A study from 2015 shows that while the 20-year average return for the S&P 500 has been 7.8%, the average investor achieved only 2.1%. That’s less than a third!

A more recent research from 2015 shows the S&P 500 down -0.7%, while the everyday investor lost -3.1%.

Average Investor Returns
Source: The Motley Fool

Don’t get me wrong, getting involved in the stock market is a good move forward to a better financial life, but luckily for us, we can do much better.

Extensive researches, top experts, and an impressive shift away from active funds all point to the same direction: the everyday investor is better off with index funds.

What is an index fund?

In 1976 the founder of Vanguard, John Boggle had already noticed that the everyday investor wasn’t very good at the stock picking game.

But actively managed mutual funds were not a great option either. Despite their high costs, they had little success in producing significant results that could outperform the market.

Not satisfied with the options and determined to give the average investors a fair chance, he then founded the world’s first and largest index fund to date, the Vanguard 500 Index Fund.

The idea behind it is quite simple: if you can’t beat ’em, join ’em!

index-investing-sp500-vs-vanguard
Source: Vanguard

Index funds are composed of the same stocks and allocations as their representing indexes, thus being called index funds. In the case of Vanguard 500, it mimics the S&P 500, the most famous benchmark for the stock market.

The advantages are:

  • It tracks the market. If you hear that S&P 500 delivers a 10-year average of 7%, you can expect your index fund to do the same.
  • Highly diversified.
  • Automatic asset rebalancing.
  • And most important, it’s low-fee.

While index funds have on average expense ratios of 0.25%, your typical active fund cost 1.5%. That’s 6 times more expensive and begs the question, “are they really much better?”

Passive vs. Active Investing

When it comes to stock investing, you can either follow the market or try to outsmart it.

With passive investing, the goal is just to mimic the market. To go with the flow, so to speak.

As we’ve seen, the passive funds are composed of the same stocks and proportions as its representing index. What we get is a low-fee fund that it’s very easy to manage, and it’s incredibly beneficial for us.

Active Investing, on the other hand, tries to beat the market. When we try to pick stocks, we are involved in active investing.doubt-picking-stocks

If you don’t trust yourself in stock picking, you can invest in an active fund and delegate this responsibility to fund managers. They will then pick the stocks and try to beat the market for you.

The problem is, not even the pros have much luck with that!

Professional Active Investors cannot consistently beat the market

“over the 10-year investment horizon, 82.14 percent of large-cap managers, 87.61 percent of mid-cap managers, and 88.42 percent of small-cap managers failed to outperform (their index benchmarks) on a relative basis.”

Academics have questioned the real efficiency of Active Investing for years now. The vast majority of studies can demonstrate with a high degree of confidence that professional fund managers cannot consistently beat the market over the long-term.

The import word here is “consistently”.

  • If you pull a list of active funds, you’ll notice that there’s quite a few that are outperforming the market in a 1 year period.
  • Increase the time to the last 3 years and you’ll see fewer results.
  • Increase to 10 years and you might see only 4 out of more than 2000 existing funds.

The numbers are pretty clear: professionals have a really hard time consistently beat the market.

Active Funds don’t live long enough

If you look at active funds, you’ll also notice that the vast majority don’t live long enough to have a substantial track record.

That’s because whenever a fund starts underperforming the market, the investment firms will pull the plug on it, and start a new one.

It’s better to start with a clean slate and sell investors on a brighter future than to spend years overcoming a huge drop in returns that forever stained that fund.

A new fund, new name, new description, and a clean slate. A lot of times the manager is still the same!

If he can keep 1 ~ 3 years outperforming, the investment company has a new fund to brag about and capture the money of unaware investors.

5 Reasons Individual investors are worse of picking stocks

If professional investors cannot consistently beat the index by deploying sophisticated portfolios, individual investors are even worse.

  1. We don’t commit the same time.
  2. We don’t know as much as they do about stock investing.
  3. We don’t have access to top research and information about companies.
  4. We suck at controlling emotions and handle a losing portfolio.
  5. We don’t have the discipline to establish a proper allocation of 30~50 assets and handle the recurrent rebalancing.

Returns might be great when all is good in the world, but issues arise when your champions become losers.

The whole idea of investing in the stock market for the long term – because in the long term it returns 10% – is only valid if you’re exposed to the totality of the market.

If you own just 5 stocks, you’re exposed to only a tiny segment of the market and won’t be able to bounce back from recessions very easily.

Furthermore, the long-term returns are not the only thing that matters. Volatility plays a huge role in your portfolio, and you need to be able to control it properly.

The bottom-line is simple, if you want to subscribe to the idea that the stock market returns 10% on the long-term, you need to invest in the total market, not only the stocks you feel like are winners.

How to invest in index funds in less than 1 minute

Passive investments are as easy to manage as they are to buy.

Step 1 – Sign in to your brokerage account

Pretty much any brokerage account will do it.
etrade-index-investing-step-1

Step 2 – Search for VFINX

Vanguard 500 Index Fund Investor Class is the most famous and stable index fund option available.

etrade-index-investing-step-2

Step 3 – Click Buy

Notice how I can’t distinguish between the fund and the S&P 500 in the chart since they walk closely all along the way.
etrade-index-investing-step-3

Step 4 – Confirm the amount and purchase

Notice that this fund has a minimum required amount of $3,000.00. If that’s a problem, you can buy VOO, which is an ETF and allows you to buy a single share by the day’s price (around $200 today).

etrade-index-investing-step-4Extra Tip: Save Money with fees

If you open a Vanguard account, there’s no transaction fee for their low-cost funds, such as VFINX.

If you’ll be automating your investments and consistently buying VFINX every month (you should), then opening a Vanguard account will save you a lot of money.

How to pick an index fund?

Once you get your hands on a couple options, here’s a few things to consider:

  • Track record: how long has it been around?
  • Lagging: how well/quick it tracks the index?
  • Expense Fees.
  • Minimum investment amount.
  • Minimum holding period.

I’d say the best index funds are the ones that can closely track their index and have low fees.

You’ll notice Vanguard has pretty much a monopoly on this space, but other firms such as Fidelity also have very compelling options.

My 401k allocation is 100% allocated to Fidelity® Total Market Index Fund (FSTVX).

All things hold equal, the cheapest expense ratio the better.

Saving 1% Expense Ratio is Saving 10 years of retirement

It’s amazing to see how small percentage point variances produce significantly different results when compounded across time.

But most people don’t realize that expense ratios also behave in the same manner!

Check this example, where saving 1% in expense ratio will give you another 10 years of retirement.

Source: Bogleheads Investment Philosophy
Source: Bogleheads Investment Philosophy

If you have an active management fund that promises superior returns (we saw this is a bad argument) but costs 1.4%, and you have a passive index fund at 0.16%, I’d take the index fund any day.

Not only the active management needs to beat the market, but it also needs to compensate for the high expense ratio. In the example below, the active fund needs to beat the index fund and another 1.24% on top (1.4% – 0.16%).

In a world where we can’t predict returns, being able to guarantee a 1.24% edge right off the bat is an amazing thing.

Now you take that 1.24% and extrapolate for 10, 20, 30 years, and you’ll see some big differences.

Takeaway

The best academics, investment experts, and the financial media have been trying to push these ideas for years now, and investors are indeed taking notice. Several reports show money pouring out from active funds and into passive funds.

I’ll admit to you that picking stocks have some appeal, but that should be reserved to your speculative investing, or what I call “my fun investment money.”

As a geek investor, I like to experiment with new stuff, even if it defies common sense or “investing best practices”. If you’re comfortable with allocating a tiny fraction for this, go ahead and use if for Stock Picking if you want!

But for the major part of your investments, trust in index investing. “If you can beat ’em, join ’em!”

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