Now that we’re almost ready to start investing, let’s take a moment to explore in more detail the reasons why we invest in asset classes rather than individual assets. Why explore this topic? Because the conclusions will dictate the types of products we’ll buy in order to invest in those same asset classes.
For many, the idea of investing means buying the stock of an undervalued company and later selling at its peak—buying and selling the right investments, at the right time. Unfortunately, that’s a losing strategy.
Studies have overwhelmingly demonstrated that—in the long term—almost nobody can beat the market by picking and choosing individual investments, a process known as active management.
This is important, for two reasons.
As a consequence, you should invest in asset classes—i.e. entire markets—rather than individual companies or assets.
You need to be aware that a huge financial industry exists to convince you otherwise. Fund managers and newsletters will try to convince you they can pick winning stocks. Remember that this industry exists to make money from you. Ignore them, and never forget the first point—that we need to be investing in entire markets.
Introduction to “indexes”
How can we invest in an entire market? It’s surprisingly easy!
A number of organizations publish what are known as indexes—which are lists of companies or assets that represent entire markets or asset classes. For example, the “MSCI US Broad Market Index” lists over 3,000 companies that represent the stock market of the United States. The “MSCI ACWI ex-USA IMI Index” lists over 6,000 companies that represent most investible stock markets outside the United States.
Indexes exist for just about every asset class in which we might want to invest—from stocks, to bonds, to commodities, cryptocurrencies, and even Chinese real estate.
Investing passively through indexed products
For years, a number of financial companies have offered investment products which track these indexes. For example, rather than purchase a single share of Apple stock, we can purchase a single share of the “Vanguard Total Stock Market ETF” product—and with that one purchase, we’ll be buying a fractional share of over 3,000 companies found in the product’s underlying index.
That’s worth repeating—with a single purchase, we can buy the entire American stock market.
Index-tracking products are referred to as passive investments, in that they just buy (or sell) the stocks of companies that belong to (or exit) the underlying index. No decisions involved. This is in contrast to active investment products, in which a manager (human or computer) is continually picking and choosing the stocks or assets they believe will beat the overall market.
How well do active products do? The results are conclusive and astounding.
In the long run, say over 25 years, the chances that an active investment manager can beat the stock market are less than 5%, as illustrated in this data borrowed from John Bogle’s, Little Book of Common Sense Investing. In summary, these data show that your chances of picking an active manager who can beat the market over 25 years is less than 5%.