Build Wealth by Watching the Grass Grow

Nobel Prize winning economist Paul Samuelson once said, “Investing should be dull.  It shouldn’t be exciting.  Investing should be more like watching paint dry or watching grass grow.  If you want excitement, take $800 and go to Las Vegas.”  This more or less summarizes our view of actively managed investments.  It may be exciting to trade stocks in an online account, trying to time the market or pick the next “hot” stock to score big gains.  It may be exciting to pay an advisor to try to outperform the market by finding the “best” stocks or actively managed mutual funds in which to invest.  But, it is not the most effective way to build wealth.

The chronic failure of individual investors to beat the market has been well-documented.  In fact, individual investors are so often wrong in the timing of their stock trades that some financial analysts use individual investor activity as a signal that they should do the exact opposite (this is known as odd lot theory).  However, professional investors trying to time the market and pick winning stocks (i.e. active managers) are scarcely more successful over the long term.  See, for example, the chart to the left on the performance of stock mutual funds over the past 15 years.  Of the 2,711 funds operating at the beginning of this time period, only 42% survived the entire 15 years and only 19% outperformed their comparable market index.  In other words, 81% either folded or performed worse than their market benchmarks.  Some investors try to improve these odds by picking managers who have outperformed in the past.  However, academic research shows that among managers who have outperformed in the past, only a small fraction continue to beat their market benchmark in the future.

So, what is the alternative?  Passively-managed investments.  Passively-managed mutual funds generally aim to mirror the holdings of a broad market index, or, even better, aim to hold all of the stocks in a particular asset class (regardless of whether the market or any particular stock appears to be headed up or down).  This investment strategy avoids or minimizes a number of factors that contribute to underperformance by active managers, including market timing risk, individual stock risk, high transaction costs, etc.  Passively-managed investments that invest in all stocks within an asset class do not try to outperform the market, but, by definition, earn market returns because they are consistently invested in the entire stock market (or the entire field of stocks in a given asset class).  Where they do try to gain an edge over the competition is by minimizing their fees–administrative and management fees passed on to the investor.  Passive investing may be the emotional equivalent of watching the grass grow, but, as Samuelson said, if you need excitement, go to Vegas.  Don’t put it all on red when it comes to your life savings.