Investing is Solved!

“Them’s fightin’ words!” Or so a character might say if I was writing a script for a 1950s Western. Nevertheless, some in the stock picker’s camp might take offence at the assertion in the title of this blog post. This seems to suggest that there is no longer a place for active investment managers. While I think the assertion is a bit more nuanced than that, let’s listen to some arguments that suggest that investing is not solved.


No, Investing is Not Solved

Active Management Can Beat the Market

Index investing can only ever match the market less the fees that are charged to manage the index fund. Active investors or investors in active funds have the opportunity to beat the returns of the market through their skillful analysis and selection of stocks.


Active Investors Can Select Superior Stocks

This is an elaboration on the point above. Active managers do not need to buy the whole market that the index tracks. Instead, they can use their analytical skills to identify and purchase the stock of companies with superior fundamentals that are likely to provide superior returns. Those who buy index funds, however, are obligated by the nature of the fund to buy all the stocks in the index, the bad along with the good. Index investors are indifferent to quality. Not so, the active fund manager.


Active Strategies Provide Better Risk Management

Passively tracking an index means accepting the good and the bad of market returns. Active investors can adjust their portfolios in response to changes in market conditions. An example of such a strategy would be to tilt toward defensive stocks like consumer staples and utilities while reducing exposure to investments that react more negatively to market downturns. Equity fund managers may even hold a significant portion of the investment in cash if the opportunities in the market are perceived as negative.


Active Strategies are Particularly Useful in Niche Markets

The arguments in favour of index investing often boil down to the efficiency of the stock market, making it very difficult for active investors to find errors or “inefficiencies” in the prices of individual stocks, especially in developed markets. However, even in developed markets, there are under-analyzed sectors that can lead to above-market returns. That advantage holds especially true in developing or so-called emerging markets.


Successful implementation of these strategies is seldom easily accomplished by the stock-picking DIY investor. This argues for the employment of investment managers to carefully select from the broader stock market a diligently researched portfolio of assets that will tend to outperform the stock market over the long run.


Actually, Investing Is Solved

That reads like a retort along the lines of “I don’t believe you, so there!” However, I think that one can make a solid argument that the investing process is solved, to a large extent, anyway. What is the solution, you ask. Invest in a portfolio of low-cost, globally diversified, broad-based index funds. Within the portfolio, keep a portion in fixed-income products that is in keeping with your capacity, ability, and need to take investment risk.


Academic and Empirical Evidence Supports the Indexing Solution

Even before the rise of investing in broad-based index investing, certain academic research began to challenge the likelihood of long-term success for active investors.


Harry Markowitz, Modern Portfolio Theory

Markowitz developed the idea that diversifying one’s investments across a variety of asset classes can lead to a reduction in risk without sacrificing returns or, from another perspective, maximizing returns given a specified level of risk. This emphasis on portfolio construction initiated a departure from the traditional approach of selecting individual stocks. With its emphasis on diversification, Modern Portfolio Theory tends to support the concept of globally diversified index portfolios.


Eugene Fama, The Efficient Market Hypothesis (EMH)

The EMH is an explanation of how markets work. In essence, it argues that all the information about a stock is already included in its price. This means that predicting the future movement of stock prices is exceedingly difficult. This can be seen in the challenges that active investment managers have in consistently beating the stock market. Speaking personally, back in the 1990s, when I first began investing with a full-service advisor associated with one of the big banks, one of the mutual funds we had bought was doing incredibly well. It had gone up 40% in less than a year. However, the performance didn’t last, and it soon began seriously underperforming the market. That fund wasn’t the first that fell from grace nor was it the last.


Burton Malkiel, The Random Walk

Malkiel is the author of A Random Walk Down Wall Street, now in its 13th edition. Malkiel, an economist at Princeton University, argues that financial markets are very efficient and hard to predict. Stock price movements are akin to a “random walk,” i.e., future price changes are unpredictable. This challenges the idea that individual investors (or active managers) can consistently outperform the market by picking stocks.


Behavioural Considerations

Building an active portfolio of individual stocks, whether taking a DIY approach or relying on a portfolio selected by a fund manager, means doing a lot of research to select what are thought to be the best investments. Since active investors make idiosyncratic choices that are different from the market, their portfolios will also perform differently than the market. The hope is that the difference will yield superior returns over the long term, but that is not guaranteed. And it is precisely this active approach, i.e., that taking action can improve the situation, that leads to poorer performance. An article by Barber and Odean found that active investors tend to underperform in their efforts to avoid losses. Index investors, who follow a systematic long-term approach to capturing market returns, tend not to react in this fashion, although it should be noted that individuals will have a wide range of responses.


Cost Effectiveness

The very nature of active investing requires active research efforts that may employ a cadre of highly educated analysts to supply fund managers with evidence to support their portfolio selections. There are relatively low-cost actively managed funds available, but they are rare. Morningstar has found that cost is the single most reliable determinant in fund performance, so this is a factor to be seriously considered. This argues for the selection of index funds as they do not engage in research to select the best securities; they simply buy and hold the index. This does not mean that an actively managed investment portfolio may not produce superior returns compared to their passive competitors; it just means that the higher cost means there is a hurdle to leap that is not easily overcome over the long term, which again favours the low cost of index investing.


Global Diversification

Index funds are by definition diversified. An investor will hold all the securities in the index that the fund is tracking, typically in proportion to their weight in the market. For example, the Vanguard FTSE Canada All-Cap Index ETF holds 176 Canadian stocks. By contrast, the TD Canadian Equity Fund holds only 53 positions.


If we push this out to the global fund category, the Vanguard All-Equity ETF Portfolio, an index fund, has over 13,000 holdings, while the Vanguard Global Equity Fund, an actively managed mutual fund, holds 178 securities.


Some will argue that even these smaller amounts reflect adequate diversification. Others will argue that concentration is the point. That is, the only way to generate market-beating returns is to focus on a relatively few holdings that research has indicated are likely to do exceptionally well. However, this lack of diversification does potentially add to the risk. And one should remember that even a globally diversified ETF like the one noted above, will still have a higher concentration in the largest of the stocks in the index that is being tracked. The point is, however, that a lack of diversification is not going to be the source of risk in an indexed investment portfolio.


Efficiency and Simplicity

As indicated earlier, active investing is a challenging process. It requires a lot of research and consequently, a lot of money to build a portfolio that is deemed likely to beat the market. It may also involve significant trading which can add to the expenses and the taxation of the investment in the hands of the investor if held in a non-registered account. Index investing, on the other hand, does not usually involve a lot of trading, except perhaps when the underlying index makes changes to its constituents. This makes management relatively simple and efficient. There is no need to pick individual stocks, no debating about whether the timing is right to engage in a desired transaction, and no shift to another sector because of a perceived change in the business cycle. Investors can focus on their long-term financial goals and use their time for other aspects of their lives.



While not impossible, active investors and fund companies that favour active investing have a hard time doing what they set out to accomplish. The efficiency of the market, although not perfect, is a challenge that is difficult to overcome. Even worse, more difficult than building an active fund that can outperform the market is the task given to individual investors to choose the fund that will outperform. I don’t want to say that it cannot be done; clearly, there are examples of such outperformance. But anyone who wants to follow that path would do well to pay attention to costs and the investment philosophy driving the active managers offering the investments one is considering. Nevertheless, given the research and the evidence, the simpler and more reliable choice is to invest in a portfolio that follows the evidence.


This is the 211th blog post for Russ Writes, first published on 2023-08-21


If you would like to discuss this or other posts, connect on FacebookTwitter aka X, LinkedIn, or Instagram.


Click here to contact me for an appointment.


Click here for a 2-week free trial of the Money Architect Financial Planning platform.


Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.


Photo by Andrea Piacquadio