Why Passive Investors Usually Win

When patients see physicians, they want advice from a trusted expert because they know that a doctor's knowledge and experience is far greater than their own.

Similarly, when they go to a financial advisor, they trust that he or she will be able to pick the winning stocks, mutual funds, or money managers, and beat the market. After all, they are pros, right?

Well, not so fast. Let's see why even the pros fail at this game.

This might get a little abstract, but bear with me because it's crucial for you to understand this, even if you don't have an advisor. The stock market consists simply of two types of investors: active investors who try to beat the market by picking the winning stocks or timing the market, and passive investors who simply own the entire market (via index mutual funds or exchange traded funds, for example).

Now let's assume that the stock market has a gain of 10% this year. By definition, if you are a passive investor you are guaranteed a 10% gain because you own the entire market.

Pay attention here: On average, it then must be true that the average active investor also has to have a 10% gain. It can't be any other way. It's simple math -- simple addition, subtraction, and multiplication.

Yes, but ... that's before fees.

We know that active investors have higher trading fees and commissions. Therefore it must be the case that the passive investor always beats the average active investor at any given moment in time simply due to fees.

Since most financial advisors, mutual-fund managers, and money managers use active investment strategies, they ultimately start off on the wrong side of the fence. And that's why the pros can't beat the market.

I know what you're thinking: "But I'm not interested in being average. I just want to hire the above average managers." Stay tuned and I'll address that objection soon.

This week’s financial prescription: Be well and stay passive.