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Each year, mutual funds tend to beat the stock market by narrower and narrower margins. If the stock picking management team behind a mutual fund does manage to put in a strong showing one year, it is nearly never able to repeat the trick a second time. Most mutual funds actually manage to underperform the market – their investors end up with lower profits than individual investors get simply by picking the best shares to buy from popular indexes like the FTSE. With almost nothing to show other than undependable performance, mutual funds usually still do charge very high management fees that tend to eat into whatever gains investors make.

What should you, the average investor, do, then? Should you pay a mutual fund a large management fee to pick the best shares to buy for you or should you pick the shares yourself by looking at a popular index and save on the management fees?

The “efficient stock market” theory proposes that beating the markets is impossible

If you’ve done a bit of reading on stock market behavior, you have possibly heard of something called the efficient market hypothesis – an idea floated in the 60s. The hypothesis proposes that investors always act rationally and pick stocks to invest based on the best information available. Since the same information is available to all investors, the market is supposed to arrange itself over time to give the best companies top pricing and the least efficient ones, the cheapest pricing.

This theory calls into question the idea that experts with special knowledge of the markets can pick winners. Since investors do indulge in buying and selling that constantly rearranges the market, the theory would imply that stocks in the market today are already priced the way they should be. There can be no predicting what stocks will go up or down as they are already where they should be.

The reality of the markets is different, though.

How markets act in reality

In practice, many investors base their decisions on insufficient, incorrect or outdated information. Many decide on the best shares to buy based on an investment style rather than purely logical methods. Some have an emotional attachment to stocks from a certain part of the country or a certain industry. Others base their decisions on rumors from the grapevine.

One reason why investors choose investment styles and gut instinct over real information is that there can be too much of it. Investment houses need to put entire departments of highly skilled staff with access to multiple streams of data to process everything necessary to make purely rational decisions about the best shares to buy. Individual investors and small brokerage businesses simply don’t have the time and manpower necessary for such data processing. In the US, one of the central aims of the Sarbanes-Oxley Act of 2002 was to help investors gain better access to information in a way that they could process.

Can you actually pick good shares to buy better than other investors?

Stock picking – the process of studying the market and using insight, statistics and knowledge to find winning stocks better than other investors – worked better when the stock markets were healthier. These days, well-trained stock pickers at major mutual funds fail to beat the results achieved by simple individual investors who simply put their money into stocks featured in the major indexes.

Mutual funds that fail to beat the markets, though, don’t actually perform worse than individual investors. Their management costs are simply so high that they end up with little profit. If you set the costs aside, most mutual funds do manage to beat the major indexes by at least a slim margin. People continue to invest in them, though, because each year, a few funds manage to beat the indexes by a healthy margin. Investors always hope that the fund that they choose may see such luck. Since the winning funds of one year end up losing their touch the following year, it can be very difficult knowing which one to pick.