We all have that friend at the golf course or family member at the dinner table who loves to brag about a lucrative trade they made in the stock market. Have you ever thought about how much they truly earned after considering the cost? “Beating the market” refers to generating a higher return than the overall market or specific market index, such as the S&P 500. Often, this means actively buying individual stocks that appear underpriced and selling them in a short time period at a gain. This article will articulate the actual costs of trying to “beat the market.”
To start, let’s consider two types of investing: passive and active. Passive investing involves replicating the return of the overall market or a particular index (S&P 500 for example) by buying the underlying stocks of the index and holding them for the long term. Active investing is a strategy that involves buying and selling stocks in the short term, aiming to earn a higher return than what the market would provide from holding stocks long-term.
Passive investing has grown dramatically over the past few decades. According to Morningstar, passive funds have attracted more inflows than active funds for the past nine years. This shift is due to the low success rate of active managers. “Most experts and experienced investors know the reason: It is just too hard for an asset manager to pick a portfolio that outperforms the market by enough to make up for the 1, 2 or 3% fee that must be charged to support the stock and bond picking strategy. Many index-style mutual funds and exchange-traded funds charge less than 0.2%, some less than 0.1%, giving them a huge cost advantage.”1
The industry has evolved quickly, and the pressure from consumers on active managers to lower their costs has had an impact. On an asset-weighted basis, the average expense ratios for mutual fund investors have substantially decreased over the past 27 years. In 1996, equity mutual fund investors incurred expense ratios of 1.04 percent per year, on average, or $1.04 for every $100 in assets. By 2023, that average had fallen to 0.42 percent per year. The average expense ratios of hybrid, bond mutual funds, and money market funds have also declined meaningfully since 1996.2 Investors must always consider costs, as they are the only controllable variable, especially when returns can vary.
Is day-trading or active management worth it? Buying and selling securities throughout the day comes with a significant cost. Data dating back to 1930 shows that if an investor missed the S&P 500′s 10 best days each decade, the total return would stand at 28%. However, if the investor held steady through the ups and downs remaining invested in the S&P 500 for the entire period, the return would have been 17,715%.3
If management costs and opportunity costs are not enough to convince you to stay away from active investing, let's look at taxes! Active management can incur significant tax costs and dramatically lower your real return. When it comes to capital gains, there are short term (for assets held less than one year) and long-term (assets held longer than one year) gains.
Dividend taxes are another important consideration for investors who buy and sell trying to beat the market, particularly when it comes to qualified dividends vs. ordinary dividends.
There is a common phrase investors should keep in mind: “It’s about time in the market, not timing the market!” When making decisions about your investments, always consider the different costs. In addition to the cost advantage, buy-and-hold investors benefit from lower taxes, the ability to capture the best market returns, and the knowledge that they can achieve more reliable, market-like returns over longer periods of time.
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Disclosures:
Apella Capital, LLC (“Apella”), DBA Apella Wealth is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered or excluded or exempt from registration requirements. Registration with the SEC or any state securities authority does not imply a certain level of skill or training. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, product or any non-investment-related content made reference to directly or indirectly in this material will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may not be reflective of current opinions or positions. Please note the material is provided for educational and background use only. Diversification seeks to improve performance by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market. Past performance does not guarantee future results. All data is from sources believed to be reliable but cannot be guaranteed or warranted.
No current or future client should assume that any discussion or information contained in this material serves as the receipt of, or as a substitute for, personalized investment advice. As with any investment strategy, there is the possibility of profitability as well as loss.