Have you ever gone to the race track and tried to pick a winning horse? With so many horses in each race, it's not easy.
Of course, it's a lot harder to pick a winner in the stock market, because there are thousands to choose from.
Yet, unlike their experience at the track, stock investors can benefit from the performance of a few winners — if they put their money in passively managed funds linked to the performance of stocks in certain indexes of the market, such as the S&P 500. This is because these indexes' performance can be buoyed by that of a few winning stocks.
For every high-performing stock, there are hundreds that lag far behind. After all, not every stock soars as Apple has. But those who invest broadly in the market, owning thousands of companies via index-type funds, can benefit from the degree to which Apple boosts overall market performance.
Between 1983 and 2008, the Russell 3000 index (representing nearly 100 percent of the entire investable market) posted average returns of nearly 10 percent annually — a whopping total return of more than 1,000 percent. Yet during this same 25-year period, about 64 percent of all the stocks actually underperformed the Russell 3000.
What saved this index? The winning 10 percent, which soared in value more than 500 percent.
Of course, things don't work the same way at the track. Unlike the market, where you can invest in thousands of companies via an index fund, the track forces you to gamble by attempting to pick winners.
Active money managers — those who speculate by attempting to pick outperforming stocks for mutual funds or clients' portfolios — persist in attempting to defy the overwhelming odds against them. And what's most unfortunate is that in spite of overwhelming academic research and evidence against this, individuals, families and institutions continue to invest with them.
Attempting to consistently outperform the markets by picking winners is simply a mathematical long shot. Sure, some get lucky on occasion, but as the evidence clearly demonstrates, according to Standard & Poor's research, the results are actually less successful than could be expected from picking stocks at random.
The difficulty of choosing winners in advance consistently and chronically is demonstrated not just by the Russell 3000 performance over 25 years but by other indexes over much longer periods. One widely regarded total market index that goes back to the 1920s returned an average of nearly 10 percent annually from then through 2009. But without the top 10 percent performers, the return would only have been about 6 percent. If you excluded the top 25 percent performers, the index's return for this period would have been in negative territory!
This long look back at market history shows the perils of trying to pick stocks and why it's a losers' game — compared with just hitching a ride on the market bus and letting the few great stocks, that are all but impossible to consistently choose in advance, more than make up for the laggard majority.
What's more, by investing this way, you'll save a lot of worry and energy by having the odds on your side instead of against you. It's as if the winning horses at the track were pulling the losers closer to the finish line to improve the average time of the entire field. Of course, this is a gambler's fantasy.
Yet, because of passive investing (like index funds), this dynamic does indeed exist in the stock market, and you can benefit from it significantly over time. Quite simply, since this opportunity does exist, why would you ever want to invest differently when you have about a one in five chance of winning?
The ordinary conception of active portfolio management involves suffering a lot of angst about choosing the right stocks. And many advisers counsel their clients not to try this alone — that it's an undertaking only for professionals. The irony is that, sadly, individuals believe such folly and pay handsomely for professionals who aren't able to even do it themselves.
Investing in institutional asset class funds or generic index funds isn't sexy or exciting like gambling. But capturing the returns of the markets that are there for the taking, and outperforming the majority of investors and money managers along the way, is extremely rewarding and gratifying.
Tim Decker, a fee-only financial planner, is president of ISI Financial Group in Lancaster. He is the author of "The Sleep-Well-At-Night Investor" and host of the radio program "Financial Freedom," which airs at noon Saturdays on WHP-AM 580. Contact him at www.isifinancialgroup.com.
This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it should not be relied upon for legal or accounting purposes. Past performance is not indicative of future performance. Investments involve risk, including the possible loss of principal. Always seek professional advice before making any financial or legal decisions.