The Frustrating Advice Given to "Beginner" Investors
It's one step away from unlocking an essential truth about investing
“Investing in index funds is great for beginners.”
I’ve read that advice from financial writers countless times… and it drives me up the wall because it’s so close to providing readers with a simplified roadmap to building wealth as a long-term investor—but it doesn’t take the final crucial step.
Investing is not a game of horseshoes; getting almost there on a coherent investment strategy doesn’t win you any extra points.
Note: Given how often I write about index investing, I will assume you know what that means. If you’re a new reader or need a refresher, here’s a crash course on passive investing with index funds.
Investing in index funds is great for nearly everyone
When finance writers tell their readers that index investing is great for beginners, it implies that as they gain more experience, they should move on to a more “advanced” form of investing.
This is simply not true.
Not only is index investing good for beginners, but it’s also good for just about anyone who wants to invest in stocks. You’re not going to beat the market, so the next best thing is to own the whole market while minimizing investment fees—that’s precisely what index funds do.
How do I know you won’t beat the market in the long run?
For the 50,000-word answer, you can pick up a copy of my book, The Rational Investor—paid MOAM subscribers can get it here.
The one-sentence answer: Over the past 15 years, 93.4% of professional investment fund managers in the U.S. have underperformed the S&P 500.
It’s possible in a short time period, you get lucky and pick the right stocks or time the market just right to outperform—but the longer the time horizon, the less likely it becomes.
If less than 7% of professional fund managers who dedicate their lives to understanding financial markets and have all the resources they would ever need at their disposal can beat the market, what makes you think that the average person will be able to do it after they move out of the “beginner phase” as an investor?
The inverse correlation between skill and ability
If you’re familiar with the Dunning-Kruger effect, you know exactly why investors with little experience believe they can do what professional fund managers can not; pick the right stocks at the right time to outperform the market.
The Dunning-Kruger effect tells us that as people gain a little bit of knowledge in a particular subject, they become wildly overconfident. They barely scratched the surface of knowledge and think they are a world-class expert.
Here’s a little drawing I made to explain the Dunning-Kruger effect:
The hopeful part is that as we continue accumulating knowledge, our confidence in our own abilities starts to diminish. When writing The Rational Investor, I read 100+ research papers on financial economics—after that, I knew enough to know how little I knew about financial markets.
The worst thing that can happen to a new investor is that they have success investing in index funds, then they start picking stocks and get lucky and pick stocks that outperform. This will cause them to believe their success was due to their brilliance rather than dumb luck. This makes it more likely they continue picking stocks and eventually learning the hard way why so few people can win at that game.
Focus on what you can control
As an investor, you can’t control what happens in the market or which stocks will outperform.
You can control:
Your asset allocation (mix of stocks and bonds)
International diversification (investing in foreign assets)
Index funds are great because they allow you to focus on all the factors listed above that you can control to build more wealth over time without taking on crazy levels of risk.
Investing is one of the few arenas in life where trying harder won’t lead to better outcomes. This is one of the hardest concepts for people to accept. Most of us want to believe that if we were smarter or more dedicated, we could outperform the market and make more money.
If there was evidence that I could have better investment returns by putting in more effort, I would do it. I don’t invest in index funds because they are low maintenance (which is an incredible benefit)—I invest in them because they give me the best odds of maximizing my net investment returns over my life.
Index funds aren’t just great for beginners; they’re great for everyone.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
The concept of being in control has helped a lot with my financial anxiety.
Focus on things you can control and things that matter, like how much you invest or how you react to the market.
Let go of the rest and worry less.
Index funds have just about every advantage a rational investor can think of, almost for free. They're unbeatable.