When it comes to investing, it’s a losing proposition to try and be anything better than average. I was recently reminded of this important investing precept when I attended a presentation by Ken French, a noted professor of finance at Dartmouth College.
"The theory is institutions are smarter than 'dumb' individuals and can add value," said French. "That is simply not true." His research has found that institutions are no better at trying to beat the market than individual investors. When you pay someone to do better than the market, French told us, "You should expect to lose. It’s really hard to identify the great managers. You are wasting your time and money trying to beat the market." (For more, see: Why Do Investors Still Choose Active Management?)
If there's no point in trying to beat the market through "active" investing, what is the best way to invest?: through "passive" investing, which accepts average market returns. You need to reduce expenses, diversify your portfolio into index funds of various asset classes, minimize taxes and exhibit discipline.
- Reduce expenses. Passive investing generally costs around 0.20% a year in fees, compared to around 1.35% for active investing.
- Diversify into index funds. Simply select an index in the asset classes you want to hold. The inherent strategy of the index will determine when to buy and sell. For example, the inherent strategy of the S&P 500 is to own a fraction of the largest 500 companies in the U.S. Every June, those companies that fell out of the top 500 largest are sold and those that made it into the top 500 are purchased.
- Minimize taxes. The limited buying and selling of passive investing tends to reduce investment-related taxes.
- Exhibit discipline. Relying on the inherent strategy of an index fund puts some distance between you and buying/selling decisions, making it easier to maintain your investment discipline during market fluctuations.
You may be thinking that, if "passive" is the way to go, you might as well make things even simpler. Why not just put your retirement money in the bank and forget it? While you can certainly do that, the results may be disastrous. If you want more than just Social Security for your retirement, you need your money to grow. (For related reading, see: Where Do Investment Returns Come From?)
Consider this. In 1913, nine cents bought a quart of milk. In 1963, the same nine cents bought a small glass of milk. In 2015, nine cents bought seven tablespoons of milk. Clearly, putting money under the mattress doesn't work for the long term. The culprit of the declining purchasing power of that nine cents is inflation. The moral of this story is to make sure your money grows at least as fast as inflation.
That requires investing it. For example, it would require $13 today to equal the purchasing power that $1 provided in 1926. Had you put one dollar in the bank in 1926, you would have $21 today. Having invested the dollar in long-term bonds would give you $132. However, invested in the S&P 500 Index (stocks), you would have $5,386.
Does that mean you should invest all of your retirement assets in stocks? If you are one year old, probably so. If you are 60 years old, probably not. For most of us, a mixture of index funds that include many asset classes – such as global stocks, global bonds, global real estate and commodities – is the best strategy.
And research supports the value of diversified passive investing as a long-term strategy. According to a study by Dalbar, Inc., average passive investors earn 3% to 4% more annually than average active investors. Over time, that makes a huge difference. (For more, see: Don’t Buy What You Don’t Understand.)