Editor's note: Originally published on August 22, 2014
Is it time to throw in the towel on stock picking (active investing)? Should everyone become an index investor (passive investing)?
As Vanguard Group, the king of passive investing, approaches $3 trillion in assets under management, and as mounting evidence shows that most investors should buy cheap index funds instead of trying to pick market-beating money managers, it's a good time to ask the question: is stock picking dead (Jason Zweig asks just this question in The Decline and Fall of Fund Managers in the Wall Street Journal).
To advocates of passive investing, there is simply no argument. The average return of the average investor is average minus fees. Therefore, to maximize returns, most people should buy cheap index funds to minimize fees. The evidence fully supports this view. Investors do a terrible job of picking money managers and timing the market. They would be better off just buying an index fund with low costs.
Most money managers lose to the market. Many who do win over 3, 5, even 10 year periods do it by luck that isn't repeated over the following 3, 5, or 10 years. Given that, the average investor is unlikely to successfully figure that out going forward.
Do some money managers beat the market? Yes. Do most of them do it by luck and not skill? Yes. Do any money managers do it by skill and over the long run? Yes. Are they almost impossible to pick ahead of time? For the vast majority of people, yes.
The money managers who do beat the market are unusually intelligent, think long term, are fiercely independent, and align their interests with their clients. Because most investors don't look for those things (they tend to look at past performance or for friendly people), and most money managers don't possess those traits, most investors should buy low cost index funds.
Suppose everyone invested in index funds? Would that make everything right in the world? The problem then would be that without anyone analyzing and pricing individual securities, securities markets useful function, price discovery, wouldn't happen. That would be bad because markets need effective pricing to work.
But, how many people need to be picking stocks to still have securities markets perform their price discovery function? No one knows the answer precisely, but it is not zero. Someone needs to analyze and price securities, or markets wouldn't work. But, the number of people doing this doesn't need to be as great as it is now (an article in the Financial Analysts Journal (not free) by Charlie Ellis, points this out).
So stock picking isn't dead, it just doesn't need to be done by as many analysts and portfolio managers as are currently doing it.
Is passive investing the right choice for most investors? Yes. Does that mean stock picking is dead? Definitely not.