When You Pay Someone to Do Better Than the Market, You Should Expect to Lose

By Rick Kahler via Iris.xyz

When it comes to investing, it’s a losing proposition to try and be anything better than average. I was recently reminded of this important investing precept when I attended a presentation by Ken French, a noted professor of finance at Dartmouth College.

“The theory is institutions are smarter than ‘dumb’ individual and can add value,” said French. “That is simply not true.” His research has found that institutions are no better at trying to beat the market than individual investors. When you pay someone to do better than the market, French told us, “You should expect to lose. It’s really hard to identify the great managers. You are wasting your time and money trying to beat the market.”

If there’s no point in trying to beat the market through “active” investing, what is the best way to invest? Through “passive” investing, which accepts average market returns. You need to reduce expenses, diversify your portfolio into index funds of various asset classes, minimize taxes, and exhibit discipline.

1. Reduce expenses.

Passive investing generally costs around 0.20% a year in fees, compared to around 1.35% for active investing.

2. Diversify into index funds.

Simply select an index in the asset classes you want to hold. The inherent strategy of the index will determine when to buy and sell. For example, the inherent strategy of the S&P 500 is to own a fraction of the largest 500 companies in the US. Every June, those companies that fell out of the top 500 largest are sold and those that made it into the top 500 are purchased.

3. Minimize taxes.

The limited buying and selling of passive investing tends to reduce investment-related taxes.

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