Wednesday, June 1, 2011

A Man's Got to Know His Limitations

I've said it before and I'll say it again:  99.9% of investors ought to forgo active stock picking in favor of index funds.  Unfortunately, most people try to pick stocks, time the market, or otherwise try to beat the odds in a game that is stacked against the little guy.  It seems as if yet another expert agrees that it pays to be passive.  In the Atlantic, Cal Tech finance professor Bradford Cornell writes quite convincingly that the little guy/gal can actually beat the big boys/girls in the investment game - but only if they invest passively.

His argument goes something like this:

1. The returns of those who invest in a passive index fund will mimic the returns of the overall market.  Let's call that amount X.

2. The returns of those who invest actively (market timing, stock picking, etc) will also mimic the returns of the overall market in aggregate.  In other words, the combined investment return of all active investors will also be X.  After all active and passive investors ARE the market.

3. However, where passive investors come out ahead is that their expenses are lower than those of active investors.  An index fund just has to buy and hold a basket of stocks that represents the entire stock market.  There aren't a lot of transactions involved, so commissions are low.  In addition, you don't need a spend time and money on research, computer programs, etc.  On the other hand, the expenses of the active investor are higher.  They are paying more in commissions because they are buying and selling more often.  They are paying more for fancy computer programs, newsletters, premium website content, etc.  Finally, they are paying more in terms of time spent researching their moves.

Some readers might reason that even though active investors will earn the same return in aggregate as passive investors, some active investors will do better and some will do worse.  This is a foolish thought.  It is human nature to think that you are better than everyone else; however, you aren't.  The people who are going to exceed market returns are those professionals who have access to research you don't have, who have access to supercomputers which you don't have, who have network connections that allow them to trade faster than you do.  In short, they have all the advantages that you, the little guy, don't have.  By the time you hear about some piece of news on CNBC, the big fish already have acted on it.  You are way too late.

However, if you stick to the relatively boring domain of passive index funds, you'll end up beating the aggregate returns of all active investors.  The article concludes with a quote from Dirty Harry which is appropriate:

"A man's got to know his limitations."

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