You don’t need to read this blog for very long in order to figure out that when it comes to investing, I am a big fan of putting money into low-cost, passive index trackers.
As an M&A (mergers and acquisitions) investment banker with access to loads of non-public, price-sensitive information, I am restricted from actively trading stocks.
However, even if I wasn’t, I cannot imagine taking an active approach to stock picking. What’s the point of wasting one’s precious energy, time and money on the utterly futile endeavour of beating the market?
Hold your horses, you may say! Surely it must be possible to beat the stock market?
Unfortunately, hard data suggests otherwise.
According to S&P Dow Jones, about 65% of actively managed large-cap funds underperformed the S&P 500 last year. On a 10-year basis, that number goes up to 85%.
And over 15 years, about 92% of actively managed funds underperform the S&P.
Not a great success rate, is it?
And it isn’t just large-cap US funds. According to data from Morningstar, the vast majority of active funds across geographies, asset classes and investment styles underperform their respective benchmarks over a decade.
That doesn’t look great either
As the evidence in favour of passive investing continues to pile up, I simply ask myself:
So why is it that despite all the evidence to the contrary, so many people still choose to put their money into actively managed funds – and suffer years and decades of underperformance? It’s a question I’ve asked hundreds of times over the years.
Before we proceed, let me make one thing clear – the intent of this post is not to beat up on active investors (as you will see if you read to the very end). But if you are serious about getting to financial independence, a subpar performance by your stock market portfolio just won’t do.
With that in mind, let’s look at some of the most common excuses you will hear from active investors:
Excuse #1: The Index Holds Good And Bad Stocks. I Want Only The Good Stocks!
Sure, so do I! But how do you know the difference?
General Motors used to be a good stock. The company was so dominant back in the 1950s that politicians floated the idea of breaking it up to avoid a monopoly. Fast forward to 2009, when GM filed for bankruptcy and it’s shareholders lost all their money.
Apple struggled to stay afloat in the 1990s. Just 20 years later, it is one of the largest and most successful companies in the world.
The issue is that success and failure are best observed through the rear-view mirror. Wanting to buy good stocks only and being able to do so are two different things.
Unless you have a crystal ball, your desire to invest in “good” stocks only will remain just that.
Excuse #2: My Portfolio Has Done Better Than The Stock Market!
There are so many problems with this statement that I don’t even know where to begin.
First, there’s the definition of performance. Too many people rely on the statements their financial advisor sends them to see how well their investments have done. As it happens, financial advisors aren’t stupid, so they employ all kinds of tricks to make the performance of their funds seem better than it really is.
They will highlight performance before fees, choose an arbitrary time period and even play around with the benchmarks – just to improve the optics. If you want an accurate answer, you better calculate the returns yourself (which is easy enough to do in Excel using the IRR function).
Second, there’s the definition of the portfolio itself. I recall speaking to one guy who claimed his portfolio outperformed the market by about 4% a year. Later on, in the same conversation, it transpired that he was including the value of his ongoing contributions when calculating his returns.
Sorry to break it to you, but if you invest £1,000 in January, add another £150 in November and end the year with £1,100, your return isn’t 10%. The true return is -4.3% – because you lost £50 on a £1,150 investment. That is the number you need to base your comparisons on.
Finally, a lot of people who claim they’ve outperformed the stock market don’t even know how the stock market has done.
For reference, the S&P 500 has delivered a 13.1% annualized return in the decade between 2009 and 2018. If you are investing in a broad-based index of large US stocks and didn’t make that much after fees, you would be better off in passive.
Excuse #3: I Only Invest In Active Funds With A Long History Of Beating The Market
No doubt. But what makes you think they will continue to do so? Circumstances change. Fund managers change. Most importantly, how do you know that past outperformance was a result of skill and not pure luck?
Allow me to introduce you to the Infinite Monkey Theorem.
It states that a monkey hitting keys at random on a typewriter keyboard for an infinite amount of time will almost surely type any given text, such as the complete works of William Shakespeare.
The same applies to active money managers. There are hundreds of thousands of people in the asset management industry taking a punt on individual stocks. A small proportion of them is bound to get lucky. And it is only the truly gifted investors (i.e. Warren Buffett) who outperform the market on the basis of skill.
There’s even a theory that Warren Buffett’s winning streak is also a result of luck. Who knows?!
Skill or luck?
What’s undeniable, however, is that history is full of examples of star managers who did well for decades – and then flamed out in spectacular ways. Bill Miller, Anthony Bolton, John Paulson, Bill Gross – and most recently Neil Woodford.
Funnily enough, all of the above were smart enough to walk away with millions, if not billions, despite the underperformance or collapse of their investment vehicles. Can’t say that about the poor individual investors who bought their funds.
Remember – just because a certain fund beat the market for the past 20 years doesn’t mean it will continue doing so going forward.
Excuse #4: I Am Not Active Because I Never Sell
Believe it or not, I’ve heard this one as well.
Holding on to an underperforming stock doesn’t make you a winner. A loss is a loss – regardless of whether you made it official by closing out your position.
Excuse #5: The Average Investor Underperforms The Market, But I’m Not Average
This is a great one. Usually, the person making the statement above goes on to explain the extensive research he or she does before buying stocks.
Did you know that 93% of Americans believe they are above-average drivers? As we all know, that cannot be true – because only half can be above average.
Take that, mediocrity!
Stock market investing is no different.
I’ve always wondered how someone who researches stocks for 10 or 15 hours a week thinks they can do a better job than hedge funds employing some of the smartest individuals in the world, armed with access to leading technology, data and expert networks.
Every trade has a buyer and a seller. When you become an active investor, you are going up against institutional players that have armies of smart people, loads of capital and much better information than you do. Just what is it that makes you think you can do better?
And that’s before we start talking about the edge that comes with having your servers right next to the stock exchanges and access to insiders who share non-public information with you.
Do you really want to be on the other side of a trade with this guy? Sure, some get caught – but many others will be on the other side of the trade you are making. Guess who will win?
Slow And Steady Wins The Race
When it comes to stock market investing, average ≠ bad. Average is actually good – because you outperform the vast majority of actively managed funds.
Next time you someone is trying to convince you of the merits of active investing, make a mental note of how many of the excuses above they bring up.
And if you are an active investor yourself, it might be a good idea to take a closer look at your investing strategy. Your strategy may well be right, but you need to make sure it’s taking you all the way to financial independence – and not leading you down a rabbit hole.
Finally, keep an eye out for Part 2 of this post – where I will lay out a few specific situations where active investing might actually make sense.
Readers – what do you think? Are you an active or a passive investor? And if you are active, what makes you think you can beat the market?
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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