Clay Finck (02:18):

So, the big question is, is stock picking and trying to get in and out of the markets a viable way to build wealth, or is there a better way for most people? Many people will tell you that simply buying a low-cost index fund that tracks something like the S&P 500 is your best bet to building wealth. Using this method, you aren’t trying to pick an individual horse in the race. You’re just owning the whole market and getting the market’s average return.

Clay Finck (02:44):

You might be thinking that the average return of the market isn’t that great. I mean, who wants to be just average? From a high level, it seems like trying to pick and choose stocks would be a good idea, especially if you’re hiring an expert to spend all of their working hours trying to beat the market. However, there was a recent study that showed that 25% of active managers underperformed passive index funds. So, even someone that receives average returns actually ends up outperforming most other investors and even most investment experts.

Clay Finck (03:16):

The word average here is a bit misleading. Average doesn’t mean that this is what the average return that an investor makes. It means that it’s the combined returns of the overall index, and most active managers underperform the market average, especially on a long time horizon. I think that a lot of people have a tough time settling for quote-unquote “average” when it comes to investing. But the reality is that simply achieving average returns actually leads to you beating most other investors. So again, the word average here is a bit misleading.

Clay Finck (03:49):

This reminds me of the famous Warren Buffett bet that many people are aware of. For those who aren’t aware in 2008, Buffett placed $1 million bet with Protégé Partners that the S&P 500 would beat a basket of hand selected, actively managed funds. He opened the challenge to anybody and this company, Protégé Partners, ended up taking the other side of the bet. This bet started around the time of the financial crisis, so initially the S&P 500 was underperforming the basket of actively managed funds. But once the overall market recovered, that performance really took a turn.

Clay Finck (04:22):

After the 10 year period, the S&P 500 increased by 125.8%, while the basket of actively managed funds only returned 36%. The average returns on those two is 8.5% for the S&P, and 3.1% for they actively managed funds, which really isn’t even a close comparison. You would think that many people that spend their entire day picking and choosing stocks would at least be able to achieve a return similar to the S&P 500, but so far that really hasn’t been the case at all.

Clay Finck (04:55):

One piece that Buffett was getting at with this bet is that these actively managed funds charge excessive fees. They’re essentially charging people money to underperform the market. So, fees aren’t really benefiting investors at all. Oftentimes these hedge funds will charge fees of 2% while the Vanguard S&P 500 fund, ticker VOO, charges a fee of 0.03%, which ends up being pretty minuscule when comparing it to about anything else. So, he was really trying to hit home that passive investing is almost always a better strategy than hiring an active manager over the long-term, because those high fees really compound over time.

Clay Finck (05:34):

In the 2013 annual letter to shareholders, Buffett wrote, “My advice could not be more simple: Put 10% of the cash in short term government bonds and 90% in a very low cost index fund. I suggest Vanguard’s. I believe the trust’s long-term results from this policy will be superior to those attained by most investors, whether it’s pension funds, institutions, or individuals who employ high fee managers.”

Clay Finck (05:58):

So, if people who devote their whole lives to trying to find alpha can’t outperform the market, why should retail investors believe that they can do it even just part-time? Let’s dive into four reasons why I believe it is just so hard to beat a passive index fund reason.

Clay Finck (06:14):

Number one: The majority of the markets returns come from a small number of the stocks. I think this is a big reason that I don’t think many people are aware of. Before being presented with the data, one might expect that roughly half the stocks in the market underperform and half outperform. It seems like a fairly logical assumption. The reality is that most stocks underperform the market, while a select few of the companies drastically outperform the market.

Clay Finck (06:41):

There was a study that looked into this data across over 1000 companies from 1999 to 2019. The average return of the overall basket to stocks was 239% over that time period, and just 26% of the companies had a return greater than the overall average. Roughly 7% of companies in the study were extreme outperformers that beat the market by more than two standard deviations, which is a total return of over 1000% over the 20 year period.

Clay Finck (07:09):

The top 10 performers included two technology names, Apple and Amazon, but the other eight in the top 10 were not in the technology sector, which I think would surprise people, as it surprised me. They included companies like United Healthcare, Humana, AutoZone, and Lockheed Martin. So, recognizing that technology was going to be a big part of our future wasn’t enough to pick the top stocks, as only two out of the top 10 were in the tech sector.

Clay Finck (07:35):

Since most of the returns come from a select few of the companies in the market, this means that you’re going to need to select some of the top companies beforehand. The stock pickers that are able to overweight those strong performers are going to enjoy extraordinary returns, should they pick the right companies to own.

Clay Finck (07:52):

Another difficulty in trying to beat the market is that top performing companies tend to be very volatile. For example, Amazon was the fifth best performing stock during the period they studied, and after the 2000 tech crash, Amazon stock declined over 90%. And after that, through 2019, it had a correction of 25% or more on five different occasions.

Clay Finck (08:15):

Netflix is another top performer. Netflix had one correction of over 70%, one correction of over 50%, and four corrections greater than 25%. So, holding many of these top performing companies is not an easy task, as you need to have the conviction to hold them through some very tough draw downs, which also means that you’re likely going to have to underperform the market by a wide margin when these companies have these large downturns. When you own all of the market, you ensure that you hold many of the winners, but you also own a lot of the losers as well. This ensures that your ride will be a lot more smooth, and will decrease your overall risk as well.

Clay Finck (08:53):

So, summing up point number one to why it’s so hard to beat the market; a majority of the returns just come from so few of the stocks, so to outperform, you’re going to have to select those outliers that just do really, really well.

Clay Finck (09:07):

Reason number two: With active management, there is some element of timing the market involved. Rather than just dollar cost averaging in, you have to decide, when is it a good time to get in and out of your positions? You might find a great company to buy, but end up purchasing it at a really bad time. So, when you’re picking and choosing stocks, you’re having to try and time the market with your picks, which has proven to be a pretty difficult task.

Clay Finck (09:32):

Reason number three why it’s so hard to beat the market: The passive indexes give more weight to your winners and less to your losers. Once many companies inevitably have very poor returns, oftentimes they will drop out of the index and be replaced by new companies. On the flip side, as your outperformers grow and do very well, these holdings naturally become a larger portion of the overall index. This reminds me of the quote, “Watering your flowers and cutting your weeds.”

Clay Finck (09:59):

So when you’re passively investing, you’re essentially letting the market decide how your portfolio should be weighted. It’s self-cleansing, in that it automatically drops the worst performers from your portfolio and continues to add to your winners. This helps boost the returns of a passive portfolio over time.

Clay Finck (10:17):

Reason number four why I think it’s so hard to beat the market: Human psychology. At the end of the day, we are all humans. Markets have a funny way of swinging our emotions back and forth, and many people get excited about their investments and they tend to buy them after they’ve gone up. They realize how great of a company Tesla was after it’s risen significantly. Then when the market corrects, they start to second guess themselves and they think that, oh, maybe they were wrong about this company.

Clay Finck (10:44):

So, it takes an incredible amount of temperament to be able to fight these temptations that your emotions and human psychology are going to push you to do. Investing and building wealth is all about buying something at a good price and letting it compound over time. If you’re prone to buying something after it’s gone up and selling it after it’s gone down, then you’re probably much better off just averaging into an index fund, as you know it’s a good performer over time, over the long run, and it’s much more stable of an investment compared to a lot of high performing companies.

Clay Finck (11:17):

A lot of times when people invest, they want to invest in something very exciting, thinking that they are buying the next Apple or buying the next Amazon that could increase in value by 10X or 20X or 30X, and most people don’t see that buying the S&P 500 and waiting for decades as something that’s very exciting at all, even though it’s proven and an almost guaranteed way to build wealth over the long run.

Clay Finck (11:41):

So to summarize my four points. One: The returns of the index are largely driven by outlier companies that are top performers. Roughly 7% of companies are the outliers that drive the majority of the market’s returns, and 74% of companies have underperformed the market returns. Number two: With being an active manager, market timing is a key component of beating the market, and timing the market is extremely difficult. Three: Passive investing is self-cleansing, as many of the losers are filtered out of your portfolio, and the winners are given more weight. And four: In order to beat the market, you must have a very strong temperament and control of your emotions to avoid buying and selling at the wrong times. The best stock pickers in the world are able to take hold of their emotions, which is also very difficult to do. Warren Buffett is a prime example of someone that has the right temperament to be a fantastic investor.

Clay Finck (12:34):

If I were to add a fifth point, I would also mention that those who hire an active manager are often paying a 1% or 2% fee to manage their money. This also makes it very difficult to beat the market, and those fees compound over time. Regardless if the fund is up or down over the year, you’ll always be paying those fees with most fund managers, making it even more costly. And people’s livelihoods revolve around this industry, so there’s a lot of marketing that goes into servicing these plans and pitch people on investing in them so they can continue to collect their fees.

Clay Finck (13:06):

A lot of people will have their index funds as the base foundation of their portfolio, and have a certain percentage of their portfolio be towards something that they think that can help them beat the market, or maybe diversify into other asset classes. This could be, say, 5% or 10% of your portfolio. The number is really different for everybody, and it has to suit your needs and your goals. You can essentially count on your index funds doing well over a long enough time horizon so you can take this other smaller part of your portfolio if you want to try and take on that challenge.

Clay Finck (13:38):

This could be through buying individual stocks or buying Bitcoin or buying commodities or buying other various asset classes. Again, the index funds would set you up for retirement, and you’d still be okay if that small part of your portfolio doesn’t end up beating the market or ends up going to zero, or does really poorly or whatever it is.

Clay Finck (13:56):

Also, I wanted to mention when preparing for this episode, I was reading through J. L. Collins’ book, The Simple Path to Wealth. My co-host Robert actually had J. L. Collins on The Millennial Investing Show on episode 41 if you’re interested in checking that episode out, and I’ll be sure to link the book and the episode in the show notes for those that are interested.

Clay Finck (14:15):

With all of this said, it isn’t to say that you shouldn’t ever invest in individual stocks. I’d say you just need to be aware of the facts and understand just how difficult it is to actually beat the market. Many people out there do enjoy picking stocks and researching companies and end up being able to outperform the market. Just realize that it does take quite a bit of work to do, and it also requires a bit of luck as well.

Clay Finck (14:39):

All right, that’s all I had for today’s episode. I really hope you guys enjoyed it. If you guys have any questions related to anything I discussed during this episode, feel free to reach out to me. My email is clay@theinvestorspodcast.com, and on Twitter my username is @clay_finck. That’s @clay_finck. I’ll be sure to get back to you when I have a chance, and then I’d be happy to try and help you guys out. Feel free to let me know if you have any ideas you’d like me to discuss in future mini episodes. Thank you for tuning in, and we’ll see you again next time.

Outro (15:11):

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