Few investors understand the long-term drag on returns that comes with active investing. Even if you guess right your share of the time, the higher volatility that comes from a more concentrated portfolio costs you money. I did a small experiment to illustrate this effect.
Jim started 20 years ago with $20,000 that he planned to invest in only Microsoft and AT&T. He gave $10,000 to one money manager with instructions to always keep the money split evenly between the two stocks.
Jim split the other $10,000 between two money managers, Alice and Betty, and instructed them to decide each day whether Microsoft or AT&T would perform better. Alice and Betty always invested all the money they controlled in one stock or the other. By coincidence, Alice and Betty disagreed every day about which stock would perform better. Each money manager alternated days between being right and wrong.
Based on this setup, the actively-managed money was invested “correctly” exactly half the time and every day one of the pots was invested correctly and the other incorrectly. You might think that the actively-managed money would end up at exactly the same portfolio value after 20 years as the even-split money management.
However, this isn’t the case. The actively-managed money grew from $10,000 to $90,042. But the even-split money grew from $10,000 to $117,918. This shows that the active money managers had to be right more than half the time just to break even. The return boost that comes from diversification is a kind of free lunch for passive investors.