If you want to reach financial independence you have to invest your money.
If you want to invest, you must learn how it’s hard to beat the Market.
Before you invest in the Stock Market, you must know that you have two basic choices: Active Investing or Passive Investing.
Active investing involves for you to choose, buy and sell single stocks, trying to beat the market and outperform its average return.
Or, if you think you can’t personally do it, you can decide to pay a fund manager to actively invest your hard-earned money for you.
If you choose Passive investing, instead, you simply buy an index fund ETF that contains all the stocks in that index and hold it for a very long time, expecting the average return of the market.
Yes, I know: passive investing is really boring. Active investing is way more exciting and it may sound like a really great idea.
“ Hey man, why I have to buy an index fund when I can simply pick the best individual stocks. If I buy only the best companies, excluding the obvious underdogs, I will surely outperform the market!”
Well, it is not so simple, because it has been demonstrated that, in the long run, it’s hard to beat the market, and almost nobody can outperform it.
If you want to get the better result, and the lowest cost possible, you have to simply buy a broad-based low-cost index fund that tracks the entire stock market.
Doing so, you have a good chance to outperform almost every actively managed fund in the long run.
Ten years ago, Warren Buffett, “The Oracle of Omaha” one of the greatest investors of all time, made a famous bet: the S&P 500 would outperform any actively managed fund considering a 10-year period.
He won the bet.
In fact, over 10 years, the S&P 500 index literally crushed 100% of all actively managed funds, undoubtedly demonstrating that passive investing is better than active investing over the long term.
It is possible to beat the Market?
Why it is so extremely difficult to outperform SP500?
A 2014 paper by J.P. Morgan demonstrated that the vast majority of investing returns comes from a little group of stocks.
They analyzed all stocks that were members of the Russell 3000 at any time from 1980 to 2014 – a database of 13,000 large-cap, mid-cap, and small-cap stocks – and discovered that 2/3 of all stocks underperformed the market average.
Only few of them, about 7%, beat the average return by more than 2 standard deviations.
Around 40% of all stocks experienced catastrophic declines (defined as a 70% decline from peak value with minimal recovery).
The result suggests that for many concentrated holders, diversification should be a central part of wealth management planning.
This gives us a crucial lesson:
1) it is highly improbable that actively managed funds will choose and pick only this extreme winners.
2) A broad-based index fund will surely hold all these extreme winners, simply because it includes all the stocks in the market.
This explain why index funds outperform active managed funds.
An index fund will always include all extreme winners, an active managed fund will not.
Obviously, over a short period of time, actively managed funds can occasionally beat an index but in the long run (+10 years) the odds are extremely unfavorable.
Picking the winners is impossible, even for the experts.
Conclusion: don’t try to beat the Market.
You also must consider the fees and expenses correlated with active investing:
- When buy/sell a stock, you pay a fee.
- If you sell a stock for a profit, you pay a capital gains tax.
- If you hold an actively managed fund, you pay a fee.
So, even if you hold an extremely performing actively managed fund, you’ll probably still lose a large part of your hard-earned money in fees and expenses.
If you want to become an intelligent investor, remember one fundamental rule: “keep it simple, keep it safe”.
Investing in index funds will allow you to keep it simple and safe and, in the long run, you’ll probably beat the most brilliant and actively managed funds.