Why You Can Beat the Stock Market but the Best Fund Managers Can't

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About 63% of actively managed mutual funds deliver inferior returns compared to the S&P 500 index in a given year. Over a five-year period, about 78% of fund managers underperform. Those jaw-dropping stats come courtesy of the semi-annual SPIVA Scorecard, which compares how active fund managers perform relative to their benchmark indexes. 

These lackluster results are often used to discourage retail investors from picking their own stocks. How can you, an ordinary investor, outperform the stock market when even the brightest minds on Wall Street can’t? Well, it turns out that you have a few key advantages over professional fund managers.

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1. You can invest while there’s real growth potential

One edge you have over big mutual funds: You can invest in small-cap stocks, those issued by a company with a market capitalization between $300 million and $2 billion. They’re worth less than the blue-chip stocks you’ll find in much of the S&P 500 index, but they have greater growth potential. The risk is higher, but they historically deliver superior returns compared to mid- and large-cap stocks.

Mutual funds are often too large to invest a significant amount in any given small-cap stock. The SEC prohibits any fund from acquiring more than 10% of an individual stock’s voting securities.Without those rules, a single fund could rapidly drive prices up and down when they buy or sell shares of a small company.

If you can correctly identify an up-and-comer, you can earn a hefty profit by investing while the stock is still a bargain. The real growth happens before mutual funds are allowed to join the party.

2. Their fees eat up your returns

Investment managers don’t work for cheap, and they still get paid even when they deliver inferior results. Actively managed funds have an average expense ratio of 0.66%, according to Morningstar‘s 2019 Annual Fund Fee Study, compared to 0.13% for passively managed funds, which try to match a benchmark index’s performance.

The difference may seem minor, but it adds up over time. If you invested $5,000 a year in a fund with an expense ratio of 0.66% and earned 8% annual returns, you’d pay $2,800 more in fees over a 10-year period than you would if you stuck with the fund with the 0.13% expense ratio. But it doesn’t matter whether the fund delivers 8%, 12%, or 0% over time; as long as you keep investing, the fund manager gets paid.

3. You can afford to ignore short-term results

Investors are more likely to react to short-term underperformance, so fund managers can’t afford not to take a short-term perspective. Morningstar research manager Michael Laske found in 2019 that the average actively managed domestic stock fund has an annual turnover of 63%. That means that a mutual fund made up of 100 stocks would replace 63 of its holdings in a given year.

Often driving the high turnover is a phenomenon known in the world of mutual funds as “window dressing,” where managers shop for the trendiest stocks at the end of the quarter — when funds with more than $100 million in assets under management have to disclose their holdings — to make their portfolios look good to investors.

The most successful investors only invest with a long time horizon of five to 10 years or more. When you take a buy-and-hold approach, you can ignore the noise that comes with fads and short-term volatility to focus on long-term results instead.

Should you try to beat the market?

If you don’t have the time or expertise to pick your own stocks, you’re better off sticking with low-cost index funds and aiming for returns that are on par with the overall market. But if you have the knowledge and risk tolerance to buy individual stocks, there’s no reason to be deterred from doing so, especially if you’re well-versed in a particular industry or sector.

That doesn’t mean you should have all your wealth invested in a few small-cap companies that you believe have the potential to become the next Amazon or Netflix. A better strategy: Aim for returns similar to the overall market with your retirement savings by investing in index funds. You can use your regular brokerage account to buy stocks that you believe have huge upside potential without putting your nest egg at risk.