the effect of the inherent costs that go with this high level of activity —costs that diminish the net returns to investors. When we factor in these costs, it becomes apparent that the active money management business has created its own downfall.
Indexing, because it does not trigger equivalent expenses, is better than actively managed portfolios in many respects. But even the best index fund, operating at its peak, will only net exactly the returns of the overall market. Index investors can do no worse than the market—and no better.
From the investor's point of view, the underlying attraction of both strategies is the same: minimize risk through diversification. By holding a large number of stocks representing many industries and many sectors of the market, investors hope to create a warm blanket of protection against the horrific loss that could occur if they had all their money in one arena that suffered some disaster. In a normal period (so the thinking goes), some stocks in a diversified fund will go down and others will go up, and let's keep our fingers crossed that the latter will compensate for the former. The chances get better, active managers believe, as the number of stocks in the portfolio grows; ten is better than one, and a hundred is better than ten.
An index fund, by definition, affords this kind of diversification if the index it mirrors is also diversified, as they usually are. The traditional stock mutual fund, with upward of a hundred stocks constantly in motion, also offers diversification.
We have all heard this mantra of diversification for so long, we have become intellectually numb to its inevitable consequence: mediocre results. Although it is true that active and index funds offer diversification, in general neither strategy will yield exceptional returns. These are the questions intelligent investors must ask themselves: Am I satisfied with average returns? Can I do better?