By Dr. Jim Dahle, WCI Founder

I’ve known about the academically proper way to invest in the stock market for more than two decades now, but I sometimes forget that not everyone knows it. From time to time, I am shockingly reminded of that fact. For those who have not yet read a half dozen or more books about index funds such as these . . .

• Common Sense on Mutual Funds by Jack Bogle
• A Random Walk Down Wall Street by Burton Malkiel
• All About Index Funds by Rick Ferri
• Index Funds: The 12-Step Recovery Program for Active Investors by Mark Hebner
• The Investor’s Manifesto by Dr. William Bernstein
• How a Second Grader Beats Wall Street by Allan Roth
• The Bogleheads Guide to Investing by Taylor Larimore et al
• The Coffee House Investor by Bill Schultheis
• Investing Made Simple by Mike Piper
• The Simple Path to Wealth by JL Collins
• Common Sense Investing by Rick Van Ness
• Unconventional Success by David Swensen

. . . you really need to read a book or two on this subject until you are convinced of the merits of index funds vs. other methods of investing in the stock market. The message you need to walk away with from these books is pretty simple. Just four words. Here they are:

Managers Don’t Beat Markets

Got it?

If not, let me explain what I mean. Better yet, I’m going to let Mark Hebner do it. He’s probably more eloquent than me anyway.

“The first step in any 12-step program focuses on recognizing and admitting a problem exists. In this case, this means identifying the behaviors that define an active investor. These include:

1. Owning actively managed mutual funds
2. Assuming prices are too high or too low
3. Picking individual stocks
4. Picking times to be in or out of the market
5. Picking a fund manager based on recent performance
6. Picking the next hot investment style (or sector)
7. Disregarding high taxes, fees, and commissions
8. Investing without considering risk
9. Investing without a clear understanding of the value of long term historical data”

How do you avoid all of this stuff? You buy, hold, and rebalance a static asset allocation of low-cost, broadly diversified, passively managed funds. Voila! You’re now investing in the stock market in the most academically sound way. The data is very clear on this topic. If you’re not investing this way, one of two things is true:

#1 You’re not familiar with the data or

#2 You believe you or your chosen manager(s) is so talented that you don’t think the data applies to you.

The first is simply an ignorance problem that can be solved with education. The second is probably an overconfidence problem that can only be overcome by recognizing mistakes—sometimes the mistakes of others but most commonly only in the school of hard knocks.

There are plenty of analyses showing that few people—actually fewer than you would expect just by random chance—possess the ability to beat the market. One of the more convincing of these is the ongoing data collection published twice a year by SPIVA. Here’s a sample of the most recent report:

The SPIVA folks have been doing this for a long time. The data looks the same every year. Basically, over long periods of time, only about 1 in 20 actively managed mutual fund managers beat the market. Bogle’s work has pointed out that on the rare occasions when they do beat the market, it’s only by a little bit. But when they underperform the market, it’s by quite a lot. And this doesn’t even take into account taxes or the value of your time to analyze all of these managers.

If all of these professionals have such a hard time beating the market, even before taxes, why in the world would you be so cocky to believe that you could do it on your own in between patients? It’s silly. Sometimes people say, “But Warren Buffett did it, so I’ll just do what he did.” It turns out that is a lot more difficult than it looks. You might also consider Warren’s advice in his 2017 shareholder letter:

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

More information here:

A Die-Hard White Coat Investor Buys an Individual Stock — An M&M Conference

Picking Individual Stocks Is a Loser’s Game

Let me share a few examples of how bad investor behavior and thought can manifest. Note that it often sounds so smart. These are actual comments left on The White Coat Investor website in the week I wrote this article (the bolding is mine):

“I think the answer is I will DCA [dollar cost average] inside the traditional IRA since a drop in the cash rate is likely to coincide with a hike in purchase price for stocks anyway aside from the likely continued upward trend—even a 2024 recession is unlikely to lower stock prices all year.”

See the issue with this one? It’s talking about predicting the future. Cash interest rates will go down. Stock prices will go up. There will be a recession in 2024. The amount of confidence behind these predictions is amazing. I would suggest that if you are this confident in your ability to predict the future, you should start keeping a journal. Write down all of your predictions. Be as specific as you can. Then go back in three months, a year, and five years, and see how you did. If you’re like most of us, you’ll become much less confident in your ability to predict the future.

“I do think investing at market top deserves a bit more discussion. While true that market tops occur quite frequently, I can understand concern about the current market top. I tend to use S&P 500 as a market proxy, and I firmly believe that valuation matters. The price-to-earnings ratio, while not a good indicator of market direction in the short term, does suggest the market is currently ‘overbought’ or expensive. At the risk of devolving into a market timing discussion, which at some level is what I am discussing, the S&P 500 is ‘overbought’ more than one standard deviation above historical averages (but less than the about two standard deviations it was overbought when we were in the S&P 500 4800 territory in early 2022). My two cents . . . and I realize this maybe runs a little contrary to Jim’s set-it-and-forget it philosophy . . . if you are considering adding a significant sum to a portfolio soon, this might be a good time to make a minor adjustment downward on one’s risk profile. I am not advocating a significant change in plan, just a slight acknowledgment that things might be expensive. Historically stock returns in far overbought territory are reduced to around what bonds typically return over time.”

Let me decipher for you. This person is predicting that the market will go down. At least he admits he’s not really very sure and so he advocates not betting the farm on this. But it reminds me of the old (likely apocryphal) story about Winston Churchill:

“Sir Winston Churchill supposedly asked Lady Astor whether she would sleep with him for 5 million pounds. She said she supposed she would. Then he asked whether she would sleep with him for only five pounds. She answered, ‘What do you think I am?’ His response was, ‘We’ve already established that; we’re merely haggling over price.’”

As the commenter noted, this was a market timing discussion. All we were haggling over was how much market timing was appropriate. Here’s another comment:

“My point being, market data should also inform your investment decisions. The markets are often near their top, but not every market top is the same. In 2015, the S&P 500 PE ratio was 20ish, a smidge above long term average, probably average for the last 30 years. In December 2021, the S&P 500 PE ratio was over 35, more than two standard deviations above norms, and higher than any point in the history of the market except 2007. Interestingly, the market ‘only’ went down to the 20 PE ratio range that year, similar to your 2015 example. From December 2022 to December 2023, the markets moved significantly upward (around 25% S&P), almost exclusively on price. Earnings are barely changed. The market is therefore ‘hot,’ not on a gut feeling, or because it’s Tuesday, but because the PE ratio is climbing and it is elevated. Said differently, the earnings yield is low. This doesn’t help anyone know what the markets will bring tomorrow. I don’t ever recommend sitting on the sidelines in cash. To me it means that stock investments in general are likely to perform less well going forward than they historically have over an extended period of time. This year . . . not sure. Next year . . . don’t know. I am underweight stocks.“

This post advocates similar tactical asset allocation (i.e. changing your asset allocation based on valuations and what you think they mean about returns in the near future). Despite admitting that he really doesn’t know what the markets will bring this year and next, he has decreased the percentage of his portfolio in stocks.

Staying the course with a good investment plan is apparently harder than it looks. If it were possible to outperform the market doing this, don’t you think some of those professional mutual fund and pension fund managers would do that? If the PE ratio of the market could predict future returns, we’d all use it. But it can’t. So, the right thing to do is to focus not on brains or brawn while investing in the market but on efficiency. Capture the market return with the minimum of fees, taxes, and hassle. How about this one:

“Agree with the general concept if you are using this phrase to describe the trading in and out of markets using some crystal ball. Yet this phrase does not apply to the question at hand. I did not see a mention of using the $150,000 for frequent trading. Not buying when the market is too hot is NOT market timing. Buying aggressively when the market is getting crushed and then holding is NOT market timing. Market timing should be contrasted with buying and holding.”

Uhh . . . OK. This comment makes “too hot” seem obvious to recognize. Well, if it is so obvious, why doesn’t everyone see that and sell all of their stocks to buy them back when the market is no longer “too hot.” While buying low and selling high is obviously a winning strategy, it breaks down when it turns out your crystal ball isn’t accurate enough to tell when the market is “too hot” or “getting crushed.”

“Warren Buffet’s (sic) BRK is sitting on $160 billion in cash/Treasuries at end of 2023. Is Warren disregarding his own misgiving about market timing? No! BRK is awaiting the irrational exuberance of the overbought market to cool down before nibbling on high value securities again. If there is recession in 2024, certainly Warren will be out on a shopping spree.”

This one is a fun comment. Not only does it make the all too common reference to Warren Buffett (who incidentally is not playing the same game you and I are, given his ability to be placed into management of the companies he acquires large chunks of), but it uses a phrase made popular back in the 1990s. BRK is an insurance company. It has a very good reason to sit on cash that has nothing to do with timing the market. “Irrational exuberance” was a phrase used by Fed Chair Alan Greenspan to refer to the market in December 1996. Here’s the full quote in classic Greenspeak:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

To Alan, the market was clearly “too hot” and “overbought.” What happened for the next three years? After making 38% in 1995 and 23% in 1996, the S&P 500 went on to make 33% in 1997, 29% in 1998, and 21% in 1999. Even when you consider the effects of the dot.com crash (-9% in 2000, -12% in 2001, and -22% in 2002), it turns out that buying at the end of 1996, when irrational exuberance was so obvious that even the chairman of the Fed was talking about it, was still the right move.

Here are more blog comments:

“I certainly am not Warren Buffet (sic)! I am much younger than him, and I don’t like McDs breakfasts. Aside from that, why would I not emulate the OG of ‘market’ investing? He has ridden the US markets for decades like a State Fair pony. Once you see something good, you emulate it. That is what we all do. Anyone here or anywhere with a novel investment concept and not emulating someone else, speak up.”

I think more money has been lost trying to emulate Warren Buffett instead of following his advice to buy index funds than by those following any other guru.

“By asking why I don’t sell when the market is overbought, you helped my argument. I don’t sell because I buy on low and then HOLD. A market timer will buy and sell and buy and sell until bankruptcy. I see values and I don’t guess trends. I get rid of appreciated stocks only when donating them or selling them to pounce on another sale. Very rarely (twice) the fundamentals of a stock went terribly bad, and I sold. Often this implies that there was inadequate due diligence on my part in purchasing.“

Just because one only uses market timing to purchase a stock doesn’t mean one isn’t market timing. The second part is more interesting, though. He mistakenly faults himself for not doing more due diligence before buying an individual stock. “If only I had studied more, then I would have been able to predict the future.” I would submit that it was impossible to know your stock was going to go bad before buying it. The mistake was assuming that due diligence would protect you. In reality, the only protection is diversification and the best diversification is just buying all the stocks, as you would in an index fund.

As Bogle would say, “Don’t look for the needle in the haystack; buy the haystack.”

“Another principle we agree on is that I don’t know where the heck the ‘market’ is going. However, as a value investor, I sure do sense the earliest signs of irrational investors’ anxiety and upcoming selloffs offering me a once in a decade opportunity. These moments are many and come every year and are not as rare as 2008 and 2020. There are 30%-50% sales today!“

Saying a stock is on sale is not the same as saying it has fallen 30% in value. It is saying that it has fallen 30% in value and IT SHOULD NOT HAVE. Thus, you can now buy the same company for a better price. It is saying that somehow you know the proper price for this company, that you’re smarter than the thousands or millions of other investors that make up the market. If you were smarter than the market, you would be a billionaire. People would be throwing vast sums at you to manage. Doesn’t it seem more likely that you’re just being overconfident about your ability to predict the future rather than you being smarter than the collective wisdom of thousands?

“Your comment that the ‘market’ usually goes up is very true for the aggregate. The fact is, there are several markets within the ‘market’ and seeking these value sectors is where I would have directed the hypothetical $150,000. Not to the overbought broad market. As the ‘market’ is at peak based on indices, what is not apparent today is that several household stocks in the telecom, pharma, and mid-range bank sectors are at 30%-50% on sale. I will take my chances on the fire sale stocks.“

This argument is that one can pick which market sectors are going to do better in the future. At least the commenter gets it right that he will be “taking his chances” (i.e. gambling) on the individual stocks he is buying.

“If you want to blindly always invest exactly the same way, reducing risk slowly as we age, that should yield average results (which is a good thing). If you want to understand why some sectors might perform better than others, why some styles might be more in favor, which international markets have different investing environments, I think that is always a fair thing to assess. The purpose of this blog is to enable professionals to comfortably control their finances. An easy portfolio is completely fine. If you want to use a bit more finesse, my suggestion is to invest 90% of your portfolio in the easy manner to get started, then take 5%-10% of your portfolio and try to manage it actively. It is a great way to learn about finance, and some might find it a fun learning experience . . . Active investing has the potential to maybe get you slightly better returns. My experience is less than 1% better than average, but it was fun to learn along the way. Maybe I’m lucky, but I don’t think it’s timing to assess market fundamentals.”

This is classic market-timer talk. Who wants to “invest blindly”? Who wants to be “average”? Who wants to just be “fine”? Don’t we all want to invest with finesse? Of course we do. Who wants to be thought of as the dumb money? Instead, I’ll try to figure out which styles and sectors are going to do better in the future and only invest in them. My favorite part, though, is that he suggests you should only invest 5%-10% of your portfolio this way. If you can beat the market, why would you only do it with 5%-10% of your portfolio instead of all of it? If you can’t beat the market, why would you deliberately underperform it with 5%-10% of your portfolio? It doesn’t make any sense. It’s not a coherent argument.

In the end, he admits he did less than 1% better than the market. That, of course, assumes he actually knows how to calculate his return. That likely is NOT an after-tax return, and it probably doesn’t take into consideration the value of his time. “But it’s fun!” he says. Well, if your idea of fun is gambling on individual stocks and likely losing money, more power to you. I’d rather go rafting or skiing or spend some time with my kids or something. Paul Samuelson, a PhD who won the Nobel Prize in Economics, said this about good investing:

“There is something in people; you might even call it a little bit of a gambling instinct . . . I tell people 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.”

Here’s another fun comment from an active investor:

“Hmmm, ‘too hot’ based on what? Based on the ‘Intrinsic Value’ of the stock! I assume you know what I am about to detail, but for other readers’ sake, let me. Each stock on the market has an actual worth that is determined by its share price, 12-months earning and the forward 2-5 years earning growth rate for the company—all publicly available info! The price you see look up today is NOT the ‘intrinsic value.’ There is even a simple formula that is a product of these factors. Well, that product is the ‘just right’ price. Below just right, it is on sale—50% down, fire sale. Above it, ‘too hot.’

Oh! There’s a formula for what a stock is worth. Why didn’t anybody tell all those mutual fund managers how to do that so they wouldn’t pay too much for stocks?

Two problems with “the formula.” The first is that forward earnings are just a projection, a made-up number. If someone asked me what my company was going to make next year, the honest answer would be “I have no idea.” I could give you a range I’d be fairly comfortable with, but it would be too wide to allow someone to tell me what the fair price for the company today would be, much less what it will be worth in a year. Plus, there is a speculative component to stock market investing. Over the long term, it zeros out. In the short term, it will dwarf the effect of earnings on the price of the stock. This simplistic understanding of how stock prices act ignores the extensive empirical data showing that stock prices are basically a random walk.

Financial journalist Jane Bryant Quinn said, “The market timing Hall of Fame is an empty room.” The stock-picking Hall of Fame is nearly as empty. The likelihood that you’re going to get into it is pretty darn low. If you truly are as talented as you believe you are, you should be managing your own money and you should be borrowing every dollar you can get your hands on and investing that. You should be managing billions for others, charging them 2 and 20 to do so. I’ve made that comment twice lately to people who thought they were hot stuff as investment managers. Both times, the reply was the same: “Thank you.” No clue that it wasn’t a serious suggestion. One person said, “Nah, I just like teaching doctors to invest.” Really? You like that better than being a gazillionaire and being able to stamp out malaria, like Bill Gates? The other person hit me up two weeks later to be the first investor in his hedge fund based on his one-year track record.

Managers don’t beat markets. They haven’t done it in the past. They’re unlikely to do it in the future. “Wall Street” is mostly a con game where managers collect fees to sell you a dream of beating the market. Don’t fall for it. Buy, hold, and rebalance a static asset allocation of low-cost, broadly diversified index funds.

In need of help on your financial journey? Over the years, The White Coat Investor has carefully curated a recommended list of professionals who have been thoroughly vetted and trusted by thousands of readers. Explore our handpicked selections today, and get the exceptional support you deserve.

What do you think? Do you believe you can time the market, pick stocks, pick sectors, pick styles, or pick managers? Why do you believe that, given the overwhelming evidence of the difficulty of the task?