How to beat the pros

Let's start by taking your favourite sport, it could be football, basketball or hockey. Imagine you could turn up to play right now in any competition and you would be instantly average in your ability and performance. Not only that, you would outperform most of your peers. No training or practice would be required just a willingness to turn up and play!

Each season there would be better players than yourself but as long as you played you would put in an average performance.. To your amusement over the years these stars would come and go but you would still be there year after year outplaying the vast majority of your competitors. Your longterm performance would be one of the best in the sport.

The odd thing is whenever you get bored and try to 'improve' your game to increase your performance you would actually become worse! You would make too many mistakes. Your skill is actually the discipline to accept you don't have that much talent and that your average ability will be highly rewarded over the longterm.

This very strange and unusual situation exists in the world of investing. By simply investing in passive index funds you can guarantee yourself an average performance and beat most active fund managers, see here and here for some examples of data.

At this point I have tried to find links to the counter arguement that active management is superior to investing in index funds. The best I could do is this. Any articles/papers/suggestions welcome!

This is not to say investing in a portfolio of index funds to capture the market return is easy. It's not. Avoiding behavioral mistakes will be your biggest challenge, especially in bear markets when you see the value of you investments going down the drain. Pulling your money out at the bottom of the market and waiting until later when it feels safe again will ruin your returns as you will miss a significant part of the recovery.

Because of the strong arguments in favour of passive investing a significant part of my investments are in broad portfolios of cheap index funds. I make some exceptions though when certain indexes are not available as funds in the Swedish market e.g. small cap and value stocks. In such cases I select the cheapest 'active' alternative.

What is interesting is that there are a multitude of  strategies that have been shown to beat stock indices (e.g there is a whole book on this 'What works on wall street') as they are fundamentally flawed in that they are market cap weighted. In fact any strategy in composing an index, including random, beats market cap weighting! link

One can make use of value, such as CAPE, P/E or P/B, size i.e, small cap or momentum to beat an index. Some approaches use even a combination, such as value and momentum e.g. here. I also invest in these type of 'active' strategies.

So why do fund managers fail to beat their benchmark indices. One explanation is that any over performance gets eaten up in fees. Another may be also that any strategy will have inevitable periods of underperformance during which the manager gets moved on or the fund is closed down.

Individual investors can exploit these disadvantages, yet still have their own psychology to contend with when underperforming the market for perhaps many years. Just take a look for example at value investing during the late 90's, which then rebounded link.