There is a discernible thrill to picking stocks correctly. Carefully considering risks, weighing possible options, and evaluating every aspect of a company, pulling the trigger, and finally seeing all your hard work pay off is extremely satisfying — and it can be very profitable too. While one must take care to avoid being sucked into the gambler’s paradise of day-trading, there is clearly an important role for the active investor, in value and growth. But there is an obvious catch: consistently successful trading is extremely difficult (read more here).
There is an ongoing debate in the financial world on the merits of active versus passive investing. Active investment funds are those in which managers actively work to pick assets so as to outperform the market. Passive investment funds, on the other hand, attempt to mirror the performance of a stock market index, or some other standard, as closely as possible, while also minimizing costs. Typically, these funds are regarded as "mutual" or "hedge" funds and have highly involved managers (i.e. activist investor Carl Icahn), while passive funds are referred to as Exchange Traded Funds (ETFs) or mutual funds, many of which are “indexed” — that is, they attempt to perfectly mirror the performance of a given index (read more about the benefits of ETFs here).
One of the main concerns surrounding activist investing is that many actively managed funds not only fail to outperform the market or a given index, but fail to even match their performance. Furthermore, actively managed funds tend to have much higher fees — it takes a great deal of time and effort, and therefore money, to constantly try to outperform the market. Thus, even if an actively managed fund beats the market, or a given index, such advantages may evaporate once management fees are accounted for.
Warren Buffet and Charles Schwab, two of the world’s most well-known investors, have both discussed the merits of investing in index funds. Besides the aforementioned low fees and consistently predictable returns, index funds offer a number of advantages, particularly for new investors. They allow investors to reap the benefits of bull markets and offer an easy way to diversify a portfolio — even without a great deal of knowledge and experience.
This doesn't that investors — even those just beginning — should avoid picking stocks and actively making investment decisions. On the contrary, it is quite difficult to gain any experience in investing if you never actually make any decisions (or mistakes). But even if you pick stocks, having part of your portfolio invested in a fund that tracks the S&P 500, or another major index, can help hedge risk — regardless of how your individual stock picks perform, you will still benefit from market gains as a whole.
Furthermore, some mutual funds and ETFs track specific sectors, or types of companies, in the same way index funds attempt to match stock market indices. While not necessarily meeting the traditional definition of indexing (as there is no actual index involved), it is quite similar and offers a greater array of possibilities. For example, such funds may attempt to track high-growth companies or energy companies within the S&P 500, or some other index, as opposed to the entire index. While you should be careful to avoid unintentionally reducing portfolio diversity, these types of funds can give investors, even those with limited experience and time, the tools necessary to make better active investment decisions — you can invest in a fund that tracks the financial sector without requiring extensive knowledge of, or exposing yourself to the risk from, individual financial companies.
In short, index, sector, and company-based funds are useful tools for all investors, regardless of how active or experienced they may be. If used effectively, these funds can hedge risk, increase diversity, and help you make better investment decisions.