Table of Contents
Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.
KEYPOINTS
Passive investing in the S&P 500 offers a superior reward-to-effort ratio for most people, especially those seeking annual returns under 10%.
Active investing demands more time, research, and risk management, which is why only a small fraction of investors outperform the market consistently.
The S&P 500's diversification and long-term stability make it a safer choice, especially for investors with lower risk tolerance
In the world of investing, there are two main approaches you can take: passive investing or active investing. While the allure of active stock picking is appealing to many, I believe that for the majority of people—especially those targeting less than a 10% annual return—investing in the S&P 500 is a smarter, more practical choice. Let’s explore why.
Passive Investing: A Proven Path with Better Reward-to-Effort Ratio
Passive investing, such as buying into an S&P 500 ETF, offers a much better reward-to-effort ratio compared to active investing.
What many hedge fund managers, mutual fund investors, or investment course sellers won’t tell you is that passive investing, despite being more efficient, goes against their self-interest. They thrive on fees, commissions, and selling courses to retail investors, which is why the appeal of active investing is often overstated. However, passive investing has been a proven path to financial success for many, with fewer risks and more consistent results.
The S&P 500 is a basket of 500 of the largest companies in the U.S., diversified across multiple industries.
One of the most appealing aspects of investing in an S&P 500 index fund or ETF is the minimal effort
required compared to active investing. Most people underestimate the time and energy it takes to succeed as an active investor. Here's why:
Low Monitoring Effort When you invest in the S&P 500, you don’t need to constantly check a company’s fundamentals, valuations, or growth prospects. Your investments will be spread across a diversified portfolio of high-quality companies that are regularly reviewed and updated. The S&P 500 index also excludes companies that don’t meet certain financial criteria, such as positive earnings, ensuring the uphold of certain financial quality of the index.
Avoid Overestimating Stock-Picking Abilities Most new investors tend to overestimate their ability to pick winning stocks. In fact, data shows that only a small fraction of individual investors or funds can consistently outperform the market over the long run.
Achieving financial success through passive investing on the other hand, is a well-proven and reliable path for the majority, while beating the market with active investing remains a challenge that few accomplish.
Historical Success of S&P 500 The S&P 500 has historically delivered annual returns of around 8–10%, which might not be as flashy as some individual stock returns, but over time, the power of compounding makes this a winning strategy. The S&P 500 is designed to reflect the long-term strength of large companies, and the dividends paid by ETFs that track it, such as SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV), and Vanguard S&P 500 ETF (VOO), provide steady income alongside growth.
Source: S&P 500 Dividend Yields
Why the S&P 500 Wins Over Time
Market Cap and Quality Filtering The S&P 500 constituents are selected based on their market cap, ensuring that only the largest and most established companies are included. This minimizes the risk of choosing weak or financially unstable businesses. The index naturally excludes companies that don't meet specific financial criteria, such as those with negative earnings in the past few quarters. [1]
A Diversified Basket Reduces Risk By investing in the S&P 500, you gain exposure to the most popular and successful companies in the U.S. with minimal chances of failure. A well-diversified portfolio in a fund like this inherently spreads risk across multiple industries. As the saying goes, “In the short run, the stock market is a voting machine, but in the long run, it is a weighing machine.” Over time, the largest and most successful companies rise to the top of the index.
Less Drawdown in Tough Economic Times The S&P 500 is less volatile than a portfolio of individual stocks, particularly when economic conditions shift. For example, during sector rotations or downturns, a single-sector-heavy portfolio (e.g., tech-focused) might experience larger drawdowns. In contrast, the S&P 500 smooths out these fluctuations by balancing multiple industries. This can be crucial for long-term savings goals, such as large down payments or education funds, where stability is key.
Why I Still Choose Active Investing
Despite the clear advantages of passive investing, I personally remain an active investor, and here’s why:
Deep Passion and Interest I love researching companies, developing financial models, and building tools to make better investment decisions. For me, the process of stock picking, portfolio construction, and rebalancing is exciting and rarely feels like a chore.
Opportunity for Higher Returns While the S&P 500 offers solid returns, my financial goals require more. My target is a 15-21.5% annual return, and by carefully selecting stocks and excluding companies that don't meet my criteria (such as those with high debt levels or negative cash flow), I believe I can achieve this. Furthermore, certain sectors like finance, materials, and utilities, while present in the S&P 500, don’t align with my personal investment philosophy, and I prefer to avoid them.
Track Record of Success Over the past 4.6 years, I’ve achieved a compounded annual growth rate (CAGR) of 16.4%, with a total return of 101% (as of point of writing on 8Oct24).
I’m confident that my active investing approach and methodologies will continue to outperform the broader market in the future. You can track my portfolio performance in real-time here and view my historical holdings here: Max Portfolio Performance.
My Advice to Most Investors
For the majority of people, I strongly recommend passive investing. Unless you have a genuine passion for the complexities of active investing, it’s best to keep things simple. A strong foundation in the S&P 500 is a smart choice, especially if your required annual return is below 10%.
In investing, there is no score multiplier for making difficult investments. -WARREN BUFFETT [BUFFETT, 2003]
If you want to explore stock picking, consider allocating only 20-30% of your portfolio to individual stocks, increasing this percentage only as you gain more skills and experience.
Lastly, keep in mind that active investing is tricky—too much tinkering can harm returns, and too little analysis can also hurt. It’s a delicate balance that few, including seasoned fund managers, get right. So, if your financial goals can be met with a return of 8-10% per year, you’ll likely be in a solid position by investing passively in the S&P 500.
For Those Who Seek to Pursue the Path of Active Stock Investing
Now that you're aware of the challenges involved in active investing but still keen to pursue higher returns, you're ready for the next step. While it demands effort and discipline, the rewards can be worth it for those willing to learn.
If you're prepared to take on this path, I encourage you to explore my Complete Guide To Create a Winning Stocks Portfolio To Achieve Your Financial Goals, where you'll find the strategies and tools needed to build a strong, long-term investment portfolio.
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