Stop Picking Random Stocks You Hear About on The Internet. Consider an Index Fund Instead

Learn why passive low-cost index funds are almost always the right choice.

During my time in the stock markets and finance in general, I have met many financial advisors who genuinely believe that index funds (ETFs) are terrible investments. Each one of them has their reasons, but many of them see investing as more of a sprint rather than a marathon, and I’m willing to bet this is one of the reasons the 90% rule is valid even today.

“90% of retail investors lose 90% of their money in 90 days.”

This kind of misinformation only hurts retail investors and secures active fund managers’ jobs. The fear of loss is the primary reason most retail investors turn to self-pronounced “financial professionals” and actively managed funds.

But ETFs are risky!

Let’s start with the classic reason active managers give as to why ETFs are bad. They argue that holding ETFs means exposure to the entire market and, because you get all the ups and downs that the market delivers, it makes them risky. Of course, the alternative would be to go with an active manager who can feel the market and, using his expertise and intuition, to protect you from a downturn, picking selected assets that he believes will do better in times of high volatility.

This alternative sounds very compelling compared to patiently waiting out for the market to turn around. Unfortunately, historical data and research do not support this theory. In a 2018 study titled Active fund performance in rising and falling markets, Vanguard compared active managers’ after-fee performance in bull markets and bear markets. If active management’s sole purpose were to help our portfolio steer through times of uncertainty and high volatility, we would expect that active management would do much better than the overall market when stocks are doing poorly. In some bear markets in the past, more than 50% of the active managers beat the market, but they failed in many others.

Our analysis shows that active managers do not display any consistent tendency to add value in bull or bear markets, and the majority tend to underperform their benchmarks over time. Because of this, we encourage investors to avoid trying to time the active-passive decision based on a particular market cycle.

If you don't believe me, or the research shared above, here's a famous quote from John Bogle.

The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently

— John C. Bogle

By now, we should have established that active management doesn’t bring much value in bear markets, which leads me to the only logical conclusion — ETFs are not riskier than active management. I would even argue that active management is much scarier than passive ETF investing.

While we know that the stock market overall is risky — it goes up and down all the time, as investors, we expect a positive return for taking on market risk β (beta). If β = 1, this means we have exposure to the broad market, and both our risk and expected positive returns are equal to the market. If, for example, by increasing leverage, we increase our risk to β = 1.2, we can consistently expect a 20% higher return for the “price” of 20% more risk. We call this type of risk priced risk.

While actively managed portfolios are also affected by the market risk β, stock-picking introduces a whole new type of risk — idiosyncratic risk. In other words, the risk that the manually picked stocks will perform well. This type of risk does not have a positive, expected return and has an unknown outcome.

Picking only the good stocks

Another common reason to avoid index funds is that you have no control over what you are buying. In an ETF, you get all of the good stocks and all of the bad stocks. Surely picking only good strong companies with a robust business model and bright future lookout should perform better than the average company.

Unfortunately, this is another good story with no data to back it up. Historically there have been massive differences between companies doing good and their stock prices doing good. While it is true that Google, Apple, Microsoft, and Amazon have been doing great over the last decade, both in terms of their business and their stock prices, there are many small and mid-sized companies like TransDigm Group, Cheniere Energy or Dexcom, that significantly outperformed the tech giants in the past decade. Those three companies grew by 2000–2500% over the last ten years. Imagine the level of luck or skill you would need to pick them without buying an ETF with exposure to the entire market.

Missing those three does not seem like a big deal, but the reality, according to the CRSP database of U.S. stocks, is that only about 4% of all stocks were responsible for 100% of the stock market returns from 1926 through 2015. Identifying and investing only in stocks that are within the winning 4% is next to impossible. No active manager or mutual fund has consistently identified winning stocks with this level of precision.

Skill vs. Luck

Although the data suggest that picking the right stocks has historically been very difficult, some active managers have consistently managed to consistently beat the market returns, even over long periods (15+ years). In theory, if you could find a skilled manager with a proven track record, then you should expect higher returns than the broad market. And that is precisely where the problem lies.

It is tough to find an active manager who has successfully managed to beat the market returns over a 15–20 year period. However, it is even harder to determine whether he did it by being skilled or getting lucky.

In a 2010 study titled Luck versus Skill in the Cross-Section of Mutual Fund Returns, Eugene Fama and Kenneth French found data supporting the existence of skilled managers who can exceed market returns without the factor of luck. The problem is that the excess return they produced was not enough to cover the fees for their services.

The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark-adjusted expected returns sufficient to cover their costs. If we add back the costs in fund expense ratios, there is evidence of inferior and superior performance (nonzero true α) in the extreme tails of the cross-section of mutual fund α estimates.

Summary

Index investing is less risky than active management and produces more stable risk-adjusted returns. Beating the broad market, in the long run, is very difficult and not many succeed in doing it. The actively managed funds and retail investors who earn a higher return do so mostly due to luck rather than skill. Skilled active investors can deliver higher returns, but they are difficult to identify. The excess return they can generate is not large enough to cover the fees for their services. For most investors, the most rational approach would be to stick with a long term, well-diversified portfolio of low fee stock and bond ETFs, with exposure to the entire stock market.