Suc­cess­ful invest­ing requires a sci­en­tific, evidence-based approach. And the evi­dence points to indexing.

Evidence Based InvestingVir­tu­ally every aca­d­e­mic study has con­cluded that try­ing to beat the mar­ket is a los­ing propo­si­tion and that a sim­ple, glob­ally diver­si­fied port­fo­lio of stocks and bond index funds (or ETFs) will serve most investors best.

Invest­ing is cer­tainly not rocket sci­ence. Any bright, curi­ous and moti­vated per­son can eas­ily under­stand the tech­niques expert investors use. If you have a long hori­zon, a bal­anced port­fo­lio of low-cost stock and bond index funds is the best defense again the bogey­man of infla­tion. Mar­kets– and cap­i­tal­ism– work.

There are two approaches to invest­ing: active and pas­sive. Active investors believe that they can out-perform mar­kets by pick­ing indi­vid­ual stocks or sec­tors, or by tim­ing their trades, or both. Pas­sive investors believe that mar­kets are so effi­cient that it is nearly impos­si­ble to con­sis­tently pre­dict mar­ket changes, and that index­ing is there­fore the smarter approach. Pas­sive invest­ing is also com­monly called index invest­ing, although tech­ni­cally an active investor might pur­chase an index fund for a par­tic­u­lar sec­tor he or she believes will out­per­form the rest of the market.

In any given year, an active man­ager will almost surely have the high­est return, and a sig­nif­i­cant per­cent­age (45%, per­haps?) of active man­agers will beat the mar­ket. The per­cent­age will appear higher due to selec­tion bias: man­agers who beat the mar­ket talk a lot more than those who didn’t. Over the long run, how­ever, all aca­d­e­mics who have stud­ied invest­ing have found that the per­cent­age that beat the mar­ket becomes van­ish­ingly small. Fur­ther­more, other than pure luck, there is no way to tell in advance which ones those will be (in econo-speak, finan­cial mar­kets are far too effi­cient for such a way to exist).

Herein lays the dilemma many investors find them­selves in. The evi­dence points to a low cost but unglam­orous approach: a glob­ally diver­si­fied port­fo­lio of index funds con­tain­ing stocks and bonds. It vir­tu­ally guar­an­tees that some­one in your cir­cle of asso­ciates, friends and neigh­bors will be brag­ging about higher returns than you saw that year. But over the long haul this admit­tedly bor­ing approach will beat almost all “pro­fes­sional” managers.

Active investors ignore more than just a crescendo of aca­d­e­mic stud­ies. Actively man­aged mutual funds typ­i­cally have sig­nif­i­cantly higher expense ratios, often an order of mag­ni­tude higher. No sur­prise there: active man­ager have to do a lot more research, ana­lyze more data, take more trips, and so on. Over time those higher expenses trans­late into lower returns.

Active investors often draw con­clu­sions from insuf­fi­cient evi­dence. Some­one reads an analyst’s “Strong Buy” rec­om­men­da­tion, and later the stock goes up. Of course the investor con­cludes this reflects skill on the part of the ana­lyst, and on the part of the investor for lis­ten­ing to that ana­lyst. But the evi­dence is insuf­fi­cient to dis­tin­guish luck from skill. Some of the smartest peo­ple in finance have been burned by this. Long Term Cap­i­tal Man­age­ment beat the mar­ket for years, rack­ing up an impres­sive track record that attracted bil­lions. They crashed when they encoun­tered mar­ket con­di­tions their mod­els did not antic­i­pate. A thou­sand years after the sci­en­tific method was devel­oped, we still have trou­ble apply­ing it.

Sim­ply put, active investors can expect to beat the mar­ket close to half the time. But the mar­ket, reflect­ing the col­lec­tive wis­dom of hun­dreds of thou­sands pro­fes­sional investors, is rarely beaten in the long run.

Evidence-based invest­ing is unglam­orous, but effec­tive. While you are regaled yet again by a friend whose returns for the year exceeded yours (it’s a dif­fer­ent friend every year, of course), take com­fort in this sta­tis­tic from the sports world; dur­ing Lance Armstrong’s unprece­dented seven con­sec­u­tive Tour de France vic­to­ries, he was beaten across the fin­ish line in 121 of the 142 total stages.