There is no shortage of lively debate about the merits of passive index investing versus active stock picking. Much of the discussion stems from one side misunderstanding the other. After reflection, I’m convinced that my choice to invest passively in index ETFs is fundamentally a statement about my own limitations.
I don’t doubt that there are stock pickers who outperform due to skill rather than luck. It seems clear enough that Warren Buffett did this throughout his career, although it's not clear whether he can continue to outperform in the future given the huge 12-figure sum he is trying to grow.
I don’t try to pick individual stocks because I don’t believe that I can beat the index consistently after costs. Proponents of active investing would be quick to point out that I can just find someone who can outperform at stock picking and invest in this money manager’s fund.
This brings me to my next limitation: I don’t believe that I can figure out which money managers will outperform. There are a few people in the active investing world I admire such as Tom Bradley at Steadyhand. However, I don’t know if they have an above-average chance to outperform. This is a statement about my limitations and not a statement about Steadyhand. Their approach to investing seems sensible and I like the way they control fees, but I still don’t know how likely they are to outperform indexes.
Maybe it isn’t even necessary to pick winning money managers. Maybe I can just find a financial advisor who can pick winning money managers for me. As you might guess at this point, I have a third limitation. I don’t believe that I can figure out which advisors can pick winning money managers.
All this sounds very weak. Am I just lacking in confidence? Those who know me well know that I have no shortage of confidence. I spent several years working with financial advisors, and then several more years picking my own stocks. My conclusion is that it is a very difficult game and I can’t do it well enough to overcome the costs of these approaches.
To those who believe they can pick winning stocks or pick winning money managers or pick advisors who can pick winning money managers I say that the vast majority of you are wrong. This doesn’t mean that you are all wrong. Maybe some are right. But I can’t tell which ones. The fact that most people whose money is actively invested will get returns below index returns is just simple math. Rather than restate the explanation of this fact, I’ll just point to William F. Sharpe’s explanation.
So for those convinced that they have skill at picking stocks, money managers, or advisors, you can pity the thundering herd of those who cannot. But know that I think the odds are strong that you are actually running along with the rest of us.