Investing in the stock and bond market
May 19, 2017
The U.S. stock market has risen, on average, roughly 10 percent annually since 1926, measured by the S&P 500 stock index. This return beats virtually all other investments over the same time period. Despite this excellent long-term performance, short-term volatility is inevitable and causes a great amount of concern among investors in the stock market.
Deciding where to invest can be a challenge, given the variety of products available and the sheer amount of financial information available today. A lot of the noise coming from Wall Street and the financial press is designed to sell and entertain. This information, if acted on, can be damaging to your investment results.
Instead of obtaining information on investing from Wall Street and the financial media, consider getting your research from Academia. This is the collection of institutions and people who are involved with teaching and research. Essentially, they are schools, think tanks, universities and colleges. In less than 70 years, academic research has made some important insights into the most effective methods of investing. Learning from this research can improve your odds of having a successful investment experience.
Active Management vs. Passive Management
“A recent study by a finance professor at Dartmouth University found that U.S. investors pay around $100 billion every year in fees and other expenses attempting to outperform the market. These costs could be avoided by simply investing in passively managed low-cost index funds.”
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There are two basic investment philosophies today, active management and passive management. Active management tries to outperform stock market and bond market indices, such as the Dow Jones Industrial Average or the S&P 500. Active money managers buy and sell securities using several techniques, such as market timing, stock picking and sector rotation.
Passive management, on the other hand, doesn't attempt to outperform the stock market. Rather, it simply attempts to capture the returns of the market by investing in a fund that mirrors a stock or bond market index. Passive investors don't try to predict future movements in security prices. Instead, they adopt a long-term, buy-and-hold investment strategy, focusing on broad diversification and keeping costs low.
The assumption underlying active management is that economic markets are not efficient. This means that some assets will inevitably be overpriced while others can be found to be underpriced; and it's possible to buy the underpriced ones and sell the overpriced assets at opportune times.
Passive money managers don't invest in this way. They avoid trying to time the market. Instead, they create a globally diversified portfolio of low-cost index or asset class funds matched with their tolerance for risk, and they avoid trying to get in and out of the market at opportune times.
The brokerage industry and the financial media have largely sided with active management. They promote the idea that outperforming the market is possible if you can just find the right stocks within the right sectors, and get in and out at the right times. Wall Street pundits like to believe that their advanced investment acumen combined with experience in stock picking can achieve above average performance.
A recent study by a finance professor at Dartmouth University found that U.S. investors pay around $100 billion every year in fees and other expenses attempting to outperform the market. These costs could be avoided by simply investing in passively managed low-cost index funds.
What does the high cost of active management get you? A second study done by the same professor, Kenneth French, along with Nobel Prize winner Eugene Fama, found that only 1 percent of money managers using active management outperformed the market. What do you think the other 99 percent did?
Is it Possible to Outperform the Market?
Active management seems to be the default investment theory. Many amateurs believe that in order to make money, you have to constantly monitor the market and use advanced insight, technology and resources to buy and sell the right stocks and sectors at the right times. The philosophy also assumes that you have to be able to predict future economic events and correctly forecast the market's response far enough in advance to make the appropriate investing decisions.
Portfolio managers who use active management try to sell their customers on their advanced stock picking ability to justify their higher costs. But these costs are part of the reason their efforts to outperform the market fall short. The ability of active management to outperform passive management, over the long-term, after all fees and expenses have been considered, is questionable at best.
A 15-year study was completed that analyzed the performance of activity managed mutual funds. The study compared the returns of these funds against a passively managed index. From 2000 to 2015, only 17 percent of stock funds succeeded in beating their benchmark index. Bond funds performed even worse. Only 7 percent of them managed to outperform an appropriate bond index. The outcome of this study is good evidence that beating the market with active management is very difficult. ❖
— Nolt is an independent registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement. To reach Nolt, call (800) 517-1031 or visit: http://www.solidrockproperty.com and http://www.solidrockwealth.com.
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