As 2015 approaches, and you begin thinking about resolutions for the new year, make changing the way you invest your first priority.
“Active investing” means trying to outperform benchmark indexes (such as the Standard & Poor’s 500 index) through market timing and stock picking. You can capture the returns of a benchmark index (less the low cost of the index fund) simply by purchasing an index fund (which tracks that index). It makes no sense to invest in active management mutual funds, unless there is a high degree of probability that your returns will exceed those of the index. The reality is that there’s a very low probability of success.
The typical way to attempt to beat the market is to identify stocks that are mispriced, usually by relying on your own research, or the recommendation of your broker or financial pundits.
Passive investing, however, which I prefer to call “evidence-based investing,” captures the returns of the global markets by using index funds with low management fees. Evidence-based investors make no effort to time the market or to select mispriced securities. Instead, they focus on their asset allocation (the division of a portfolio between stocks and bonds), keeping costs and fees as low as possible, and finally, tax efficiency.
Problems with active management. In order to achieve success as an active investor, you have to believe in your ability to outguess the market. You (or the fund manager in the actively managed mutual fund you purchase) will buy individual stocks you (or the fund manager) believe will outperform. You will sell stocks when you think they are overvalued. An often overlooked problem with buying and selling stocks is that it’s expensive. High transaction costs adversely impact your returns.
A more fundamental problem with active management is the low odds of success. According to S&P Dow Jones Indices data for the end of 2013, the majority of active managers across all domestic equity categories did not provide investors with returns higher than their benchmarks over three or five-year investment horizons. There is also no reliable way to identify funds likely to repeat stellar past performance.
Benefits of evidence-based investing. Instead of trying to outguess the market, evidence-based investors accept the fact that the market (which consists of millions of traders) does a very good job of pricing stocks and bonds. Evidence-based investors don’t engage in the low-probability game of trying to outguess these collective traders.
By keeping costs low through the use of low management fee index funds, evidence-based investors increase the odds of beating the returns of active investors because of the difference in expense ratios. Evidence-based investors don’t try to predict the direction of the markets, or which mutual funds are likely to repeat their outperformance. They understand most actively managed mutual funds are likely to underperform their benchmarks and past performance is not likely to persist.
Evidence-based investors heed this admonition from Nobel laureate Merton Miller:
“Most people might just as well buy a share of the whole market, which pools all the information, than delude themselves into thinking they know something the market doesn’t.”
Investors are getting smarter. According to an Aug. 6 Morningstar article by John Rekenthaler, vice president of research for Morningstar, net sales over the 12 months ended June 30, 2014 for all index-based funds (index funds, exchange-traded funds and passive mutual funds) accounted for 68 percent of net sales. Clearly, for this period, investors concluded the cost of active management was so high, and the potential for incremental returns so low, that it was not a game worth playing.
According to University of Scranton research, only 8 percent of Americans successfully keep their resolutions for the new year. Many fail by the end of January. If there’s one resolution you should make sure to implement, it’s to become an evidence-based investor. It is the only intelligent and responsible way to invest. You owe it to yourself and to your loved ones.
The only prediction I ever make when it comes to investing is that evidence-based investors are more likely to have a happy new year (and beyond) than those engaged in active management.
Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is “The Smartest Sales Book You’ll Ever Read.”
More from U.S. News
Your 7-Step Checklist to Choosing a Financial Advisor
6 Steps to the Retirement Lifestyle You Want
10 Steps for Retiring Entrepreneurs
The Active or Passive Fund Debate is Over originally appeared on usnews.com
