Like a bad houseguest, hotter-than-expected inflation continues to linger in the US.

Traders had hoped by now the Federal Reserve would be free to start cutting interest rates — boosting rate-sensitive stocks and unlocking a largely frozen real estate market. Instead, stubborn price growth has some on Wall Street rethinking whether the central bank will lower rates at all this year.

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You don’t have to be a stock market genius to outperform most pros.

You might not think it’s possible to outperform the average Wall Street professional with just a single investment. Fund managers are highly educated and steeped in market data. They get paid a lot of money to make smart investments.

But the truth is, most of them may not be worth the money. With the right steps, individual investors can outperform the majority of active large-cap mutual fund managers over the long run. You don’t need a doctorate or MBA, and you certainly don’t need to follow the everyday goings-on in the stock market. You just need to buy a single investment and hold it forever.

That’s because 88% of active large-cap fund managers have underperformed the S&P 500 index over the last 15 years thru Dec. 31, 2023, according to S&P Global’s most recent SPIVA (S&P Indices Versus Active) scorecard. So if you buy a simple S&P 500 index fund like the Vanguard S&P 500 ETF (VOO -0.23%), chances are that your investment will outperform the average active mutual fund in the long run.

Image source: Getty Images.

Why is it so hard for fund managers to outperform the S&P 500?

It’s a good bet that the average fund manager is hardworking and well-trained. But there are at least two big factors working against active fund managers.

The first is that institutional investors make up roughly 80% of all trading in the U.S. stock market — far higher than it was years ago when retail investors dominated the market. That means a professional investor is mostly trading shares with another manager who is also very knowledgeable, making it much harder to gain an edge and outperform the benchmark index.

The more basic problem, though, is that fund managers don’t just need to outperform their benchmark index. They need to beat the index by a wide enough margin to justify the fees they charge. And that reduces the odds that any given large-cap fund manager will be able to outperform an S&P 500 index fund by a significant amount.

The SPIVA scorecard found that just 40% of large-cap fund managers outperformed the S&P 500 in 2023 once you factor in fees. So if the odds of outperforming fall to 40-60 for a single year, you can see how the odds of beating the index consistently over the long run could go way down.

What Warren Buffett recommends over any other single investment

Warren Buffett is one of the smartest investors around, and he can’t think of a single better investment than an S&P 500 index fund. He recommends it even above his own company, Berkshire Hathaway.

In his 2016 letter to shareholders, Buffett shared a rough calculation that the search for superior investment advice had cost investors, in aggregate, $100 billion over the previous decade relative to investing in a simple index fund.

Even Berkshire Hathaway holds two small positions in S&P 500 index funds. You’ll find shares of the Vanguard S&P 500 ETF and the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) in Berkshire’s quarterly disclosures. Both are great options for index investors, offering low expense ratios and low tracking errors (a measure of how closely an ETF price follows the underlying index). There are plenty of other solid index funds you could buy, but either of the above is an excellent option as a starting point.

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Canadian investors might come across a lot of arguments out there for or against index funds and stocks. When it comes to investing, some might believe clicking once and getting an entire index is the way to go. Others might believe that stocks provide far more growth.

So let’s settle it once and for all. Which is the better investment: index funds or stocks?

Case for Index funds

Index funds can be considered a great investment for a number of reasons. These funds typically track a broad market index, such as the S&P 500. By investing in them you gain exposure to a diverse range of assets within that index, and that helps to spread out your risk.

These funds also tend to have lower expense ratios compared to an actively managed fund. They merely passively track an index rather than a team of analysts constantly changing the fund’s mix of investments. This means lower expenses, and lower fees for investors.

Funds also tend to have more consistent returns compared to individual stocks, which can see significant fluctuations in value. You therefore may enjoy an overall market trending upwards over the long term. This long-term focus can then benefit investors from the power of compounding returns, growing wealth significantly over time.

Case for stocks

That doesn’t mean that stocks can’t be a great investment as well. Stocks have historically provided higher returns compared to other asset classes over the long run. When you invest in stocks, you’re buying ownership of stakes in a company. This ownership then entitles you to a share of the company’s profits through returns or dividends.

Investing in a diverse range of stocks can then help spread out risk. Whereas an index fund is making the choice for you, Canadian investors can choose the stocks they invest in, creating the perfect diversified portfolio for them.

What’s more, stocks are quite liquid. This means you can buy and sell them easily on the stock market, providing you with cash whenever you need it. What’s more, this can be helpful during periods of volatility in the economy, providing a hedge against inflation and the ability to sell to make up income.

In some jurisdictions as well, even if you lose out on stocks you can apply capital losses, reducing overall tax liability in the process. And while it can be challenging, capital gains can also allow you to even beat the market!

So which is best?

I’m sure some people won’t like this answer, but investing in both is definitely the best route to take. If you’re set in your ways, that can mean you’re losing out on the potential returns which you could achieve by investing in both of these investment strategies.

A great option that would provide diversification is to invest in strong Canadian companies, while also investing in diversified, global index funds. For instance, consider the Vanguard FTSE Global All Cap Ex Canada Index ETF Unit (TSX:VXC), which provides investors with a mix of global equities, all with different market caps. This provides you with a diversified range of investments that over time have seen immense growth.

This index does not invest in Canada, so you can then couple that with Canadian investments. Think of the most boring areas of the market, and these can provide the safest investments! For instance, we always need utilities. So investing in a company such as Hydro One (TSX:H) can provide long-term growth. What’s more, it’s a younger stock compared to its utility peers, providing a longer runway for growth. And with a 3.15% dividend yield, you can gain extra passive income as well.

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