Index Funds Are Great, But Active Investing Has Its Place

I like index funds as much as the next guy. The incredibly low expense ratios. Ease of purchase. And most of all: they blow away active fund managers.

But from where I sit, I see several reasons why it can make sense to actively manage investments. To *gasp* pick stocks.

Before you pick up the pitchforks, let me clarify a bit:

I am going to argue that active investing has its place for a small minority of people for a – perhaps larger, but still minority – percentage of their assets.

Why Listen to Me?

I’ve been managing my own portfolio since I was 16. No, I haven’t outperformed the S&P 500; though it would be a different story if I removed my teenage years.

But I’m a perfect example of how actively investing a small sum – before I was old enough to register an account under my own name – paid off. Not in dollars and cents, but in education.

Having some skin in the game helped to spark my finance career. What I learned from the markets, and from all of the books I read to become a better investor, gave me a massive head start over my peers in college.

(There were a few exasperated professors that chastised me for skipping class, but begrudgingly gave me high marks.)

The point is, if my 19-year-old cousin told me he aspired to a finance career, one of my (many) pieces of advice would be to take a couple grand and manage it himself.

So, that’s a situation where it makes sense for someone to run their own portfolio. But it’s a situation where the decision comes down to more than the profits and losses.

What about for the rest of us? What about when the P&L is the only factor at play?

It depends on the individual.

For those that are not prepared to make the markets a major part of their lives, index funds are almost always the best option. But those that are prepared to put the time in just might want to run an account of their own.

The Savvy Individual Investor Has Some Advantages Over Fund Managers

The key word here is “savvy.” Most retail investors perform poorly; they might as well throw darts at the Wall Street Journal.

But the savvy ones – which I mostly define as being educated and hard-working, not geniuses – do hold two advantages over the fund managers:

1. Their small size gives them access to attractive opportunities.

Small-cap stocks generally have a market cap between $300 million and $2 billion. Micro-cap stocks are even smaller; $50 million to $300 million.

Stocks in these two categories are often too small to warrant much attention from Wall Street and fund managers. It makes sense when you think about it: if a $10 billion fund loves a $300 million company, it can’t really buy enough shares for it to be worth its while – certainly not without moving the stock.

But the small investor running an account in the thousands? They can buy as much of any micro or small-cap stock as they want.

Furthermore, the lack of institutional coverage does something else: it increases the chances that those types of stocks will be mispriced, which sometimes means undervalued.

2. The retail investor has no one to answer to.

“You ever wonder why fund managers can’t beat the S&P 500? Because they’re sheep, and sheep get slaughtered.” – Gordon Gekko.

Harsh, but in many cases, true. But why? One of the big reasons is that they have clients to answer to.

If they go out on a limb with a few picks, and the investments fail? “Why did you buy those awful stocks? My brother-in-law’s funds are up 20% this year!”

On the other hand, if they buy what everyone else is buying? They won’t hit it big, but their clients will be (mostly) happy. The client, however, is often the loser; they would have been better off buying an index fund due in large part to the much lower fees.

The individual investor has no one to answer to. They don’t have to worry about ostracization, client outflows, and destitution (assuming they invest what they can afford to lose). Using other people’s money (OPM) is all well and good, but it’s restrictive.

If an individual investor believes a contrarian idea is the best idea, there’s nothing stopping them.

Are We Telling the Next Buffet to Invest in Index Funds?

We don’t tell young basketball players, “Look, it’s a one-in-a-million shot that you’ll make the NBA, so you should stop spending so much time playing.” But we often do the same with young, aspiring investors.

You might be poking holes in the comparison, but are they really that different? Yes, playing basketball has utility beyond the potential of making the NBA, but so does investing, as I showed before.

The young, aspiring investor should instead, like the basketball player, be cautioned that it’s really difficult to make a living investing in the markets, but they should chase their dream without betting the house or neglecting their other studies.

Besides not (unjustifiably) crushing kids’ dreams, there is the potential benefit to the collective that is being foregone if we push everyone to index funds. The markets are far from perfect, and by saying, “just buy index funds,” we could be pushing would-be innovators away from making markets better for all of us.

The Final Word

You may not agree with me on all my arguments, but at the very least, I hope this article got you thinking.

I can’t say it enough: index funds are great. I would venture to say that they’ve been one of the greatest innovations for the investments industry.

But I do think we’ve gone a bit too far in the direction of index funds, and should acknowledge that they aren’t the be-all and end-all.

Active management shouldn’t be sent to the scrap heap of investment history; instead, it should be selectively deployed.

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