You can't beat the market, so stop trying
(MoneyWatch) I have been fielding a lot of questions lately about purchasing individual stocks in retirement accounts. While the allure of finding the "next big company" can be compelling, how many investors have the knowledge, time and energy to devote to building and maintaining a portfolio of individual stocks? In my experience, very few. And more importantly, the odds of success are against them. Numerous studies have found that beating the market is hard ... really hard!
To see just how difficult it can be, look no further than mutual fund professionals, who are supposed to have the skills, staff and connections necessary to beat the relevant stock indexes against which they are compared. While about half of fund managers best their indexes (before fees) in any given year, very few do so consistently.
Part of manager underperformance can be explained by the annual fees involved in actively managed funds. These include management, administrative and distribution (or 12(b)-1) fees, and commissions or "loads," all of which can add 2 to 3 percent in costs. Fees are an enormous drag on long-term performance, which is why I recommend that you stick to low-cost index funds.
Charlie Ellis on active vs. passive investing
Even without the fees, beating the market is still difficult. Charles D. Ellis, a consultant to large institutional investors, discussed the challenge his profession faces in a recent article in the Financial Analysts Journal called "The Winner's Game". He noted that, "Most investors are not beating the market; the market is beating them. ... And it's much, much harder to beat the market after costs and fees." Ellis found that the percentage of mutual fund managers who lag their relative index, after fees, is 60 percent in any one year, 70 percent over 10 years and 80 percent over 20 years. The numbers speak for themselves: only one in five managers beats the index over the long run!
Ellis is a consummate insider of the investment management business, which is why we should pay attention when he practically begs his colleagues to stop selling the fallacy of beating the market. "[W]e continue selling what most of us have not delivered and, realistically, will not deliver: beat-the-market investment performance. Most investors have not yet caught on to the fact that they would be better off if they put most of, if not all, their investments in low-cost index funds or index-matching exchange-traded funds."
Ellis is not the lone voice on the topic. David Swensen, the chief investment officer at Yale University, advises individual investors to "invest in a well-diversified portfolio of low-cost index funds." And even the Oracle of Omaha, Warren Buffett, has said that the best bet for an individual investor "is to just buy a low-cost index fund and keep buying it regularly over time. ... If you have 2 percent a year of your funds being eaten up by fees, you're going to have a hard time matching an index fund in my view."
Here's the funny thing: I have explained the poor odds and recited these quotes to clients, and yet many of them still believe that they can identify and grow rich from the next Apple or Google stock. While optimism can be a wonderful thing in life, it may be better to be objective when it comes to investing. Academic data suggests that even when there are cases of investors beating the market, the outperformance is a result of good luck. Good luck is nothing to sneeze at, but relying on it as a retirement strategy is unwise.
If I haven't yet convinced you to avoid individual stocks, then make sure that you limit your downside risk. The best way to do so is to keep your individual stocks to a small portion of your overall portfolio -- say five percent of your total invested assets. This way, stock picking can be an enjoyable hobby and an interesting intellectual diversion, but not something that could decimate your savings and retirement funds.
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