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In recent years, the art of stock picking has fallen somewhat out of favor. Many investors now prefer passive or "index" investing for various reasons.

I'm certainly not opposed to index investing; in fact, I believe that it can certainly be beneficial for investors in various categories. For example, I recently advised a teenager who saved $500 from working a summer job to invest his savings in the SPDR S&P 500 ETF (SPY), which is obviously an index fund.

Despite the fact that index funds are certainly appropriate in certain situations, it troubles me when I see advice like the following:

Aim to own at least 3 or 4 non-correlating asset classes ... buy only index funds. - Kyle Bumpus, AmateurAssetAllocator.com

I'm not completely against index investing. I personally hold both the Vanguard REIT ETF (VNQ) and the iShares MSCI Emerging Markets Index (EEM). Nonetheless, I think investors should be aware of the facts from all sides before rushing to allocate their entire portfolio to index funds.

I'm planning to break down this article into several parts, taking a deeper look at several common misconceptions about index investing.

1: Are Equity Index Funds Better Than Equity Mutual Funds? Not Necessarily

Mutual funds have, to some extent, become the villain du jour of the investing world. Many investors are tired of paying high fees to money managers to see mediocre-at-best returns.

Despite some of these concerns being valid, the idea that money managers are totally useless and should be shunned is a little extreme. Some money managers are brilliant, and have a habit of beating the market by picking the right stocks. For example, despite mediocre returns over the past decade for the S&P 500, take a look at the performance of Don Yacktman's Yacktman Focused Fund and Will Danoff's Contrafund. Both of these men have very strong track records.

Shows growth of a hypothetical $10,000 investment in Yacktman Focused over the selected time period.

The value of a great money manager is even more evident in down markets. While an investor in the S&P 500 has barely broken even over the past five years, an investor in Danoff's Contrafund or Yacktman's Focused Fund have actually seen pretty nice gains.

Shows growth of a hypothetical $10,000 investment in Yacktman Focused over the selected time period.

Now, there are a few important things to remember. First, those who have read my previous articles know that I believe the long-term outlook for the stock market as a whole is bullish, so I am by no means predicting a "bad" return for the S&P 500 in the future. Second, even great funds can fall, as demonstrated by the cautionary tale of the Magellan Fund.

Still, if you can find a really solid money manager, chances are you'll absolutely destroy the market over the long term. Over the past two decades, investors in Warren Buffett's conglomerate Berkshire Hathaway (BRK.B) have doubled the market's performance. This performance is even greater over the long term - since 1965, Berkshire is up over 513,000% vs. 6,400% for the S&P 500.

BRK.A Chart

BRK.A data by YCharts

2: Is Stock Picking Dead? The Better Question: How Can Stock Picking Ever Be Dead?

The market-beating performances I mentioned above could theoretically be ascribed to luck or random chance. However, I don't believe this is the case.

I don't believe in the efficient market hypothesis, which asserts that beating the market, over the long term, is impossible. Why don't I believe this? Because bubbles happen and stocks are improperly valued, every day, all the time. Yes, the same information is theoretically available to every investor, but that doesn't mean they all read it - or draw the same conclusions. For example, take the recent Facebook (FB) IPO. Of all the mom-and-pop retail investors who rushed to buy Facebook when it went public, how many do you really think read the S-1? This isn't an indictment of retail investors, but rather, an acknowledgment of the fact that some people take the "buy what you know" paradigm much too literally.

The fact that many stocks are irrationally valued should concern index investors because it means that when buying an index fund, you may be buying a bunch of overvalued companies in addition to some fairly valued ones. In the long term, this leads to a self-defeating strategy, as examined by John Plender of Financial Times:

Since the weight of securities in an index is dictated by market capitalization, there is a tendency for passive managers to invest more in shares that are becoming overvalued. ... By the same token, when shares have gone down, causing shrinkage in market capitalization weight, they have to sell them. This amounts to a value-destroying injunction to buy high and sell low.

Buying an index fund, then, is like buying a large sack of randomly selected vegetables. Some of the vegetables may be unripe or rotten, and you might get too much of something you don't need or want. (What am I supposed to do with ten pounds of tomatoes? True story.)

The art of stock picking is no more dead than the art of vegetable picking - you just look for good quality at a good price. This is how Yacktman, Danoff and Buffett consistently beat the market. They separate the wheat from the chaff, and buy only what's looking tasty.

It's important to realize that the recent trend of stocks moving together like a school of fish won't last forever. In time, things will change, a point made eloquently by Vincent Fernando at Business Insider in an article titled "If Stock Picking is Dead, Then Index Investing Is Completely Broken." His thoughts:

while stock picking is out of fashion right now, it's pretty easy to imagine how in ten years time we'll look back and think 'Wasn't it just ridiculous how so many people thought that buying the most popular 500 stocks blindly, without any analysis of the companies, was smart?

So essentially, stock picking isn't dead, and it can't be dead. As long as there are overvalued companies like Facebook and undervalued companies like Intel (INTC), I think it makes more sense to choose the good stocks rather than blindly buying a bunch of stocks that range from "terrible" to "awesome." Whether you choose to do this by purchasing a mutual fund or conducting your own analysis and holding individual stocks, I believe it will lead to better long-term returns.

3: Indexes Ignore The Real World

As established above, index funds buy and sell based on an index - essentially a trumped-up list. Actions are not based on any real-world factors. While this is, in my mind, bad all around, it's especially bad in certain markets.

Take, for example, bond markets. A passive global bond fund ignores many relevant developments in the bond markets, including an all-but-certain default in Greece and a troubling bubble in U.S. Treasuries. The potential implications for investors in international bond funds? Severe.

What's the worst that could happen for international bond investors? A collapse of the euro. Greek bonds have taken a 50% haircut, and Portuguese bonds are also getting clobbered.

Index investing looks even worse in certain markets like the junk market. Morningstar has an in-depth article covering many problems in junk-bond indices:

Many junk bonds trade irregularly, so index prices are often estimated using "matrix pricing" models, which produce interpolated prices based on a handful of reference bonds. These prices are often impossible for investors to obtain. If so few funds can get close to the index's returns, then the index's returns are fiction.

This is yet another reason to avoid index funds in some areas. Actively-managed funds may charge slightly higher fees, but in return, you get active management (as the name suggests). In circumstances like the present, this can be helpful, as actively-managed funds can move money out of South European bonds.

Conclusion

While index investing can certainly provide benefits, investors shouldn't believe that passive index investing is a one-size-fits-all solution. I personally hold a few index funds, as I mentioned in the introduction, but I generally prefer either investing my money in stocks of my choice or leaving it in the care of a money manager I trust.

Index funds generally aren't for me, but many others may disagree. What's your stance on index investing? How extensively do you believe it should be used, in terms of asset allocation?

Source: Index Investing: One Size Doesn't Fit All

Additional disclosure: I hold stakes in both the Yacktman Focused Fund (YAFFX) and the Fidelity Contrafund (FCNTX).