Unless you're Warren Buffett, you're better off investing in an ETF, top economist says

Picking stocks is a lot like gambling, in that you’re never really sure if you’ll hit a winner or be stuck with a bad hand. But there’s an alternative to picking individual stocks: index funds. Princeton’s Dr. Burton Malkiel has favored index funds over stocks even before they existed - he joined TheStreet to discuss.

Full Video Transcript Below:

SARA SILVERSTEIN: You famously favor index funds over individual stock picks and way before index funds existed, as they do today. You've been long proven, right? Can you just give us a little bit, why is this the best strategy for retail investors?

DR. BURTON MALKIEL: Well, it's the best strategy because it works. The standard and Poor's corporation does a study. It's called a SPIVA study. And that stands for standard and Poor's indexes versus active management. And what they do each year is to compare how active managers did versus a simple index fund. And year after year, what you find is that in any given year, about 2/3 of active managers are outperformed by a simple index. And the one third that win in one year are not the same people who win the next year. So that when you compound this over 5 and 10 years, you find that 90% of active managers are outperformed by a simple index. And over 10 and 20 years, it's well over 90%. 

So I'm not saying that active managers can never perform. There are some who have, and who have over long periods of time. But for the individual investor, if you try to go active, if you try to find that great manager, you'll find that you're much more likely to be in the 90% of the distribution that underperforms rather than the 10% of the distribution that outperforms. And the problem is you can't just pick the best manager by who's done it in the past. Certainly Warren Buffett is one of the people who, over long periods of time has absolutely trounced the index. But if 10 years ago you said, well, I want to invest in Berkshire Hathaway because they've trounced the index, you would have found that in the last 10 years, even Warren Buffett underperformed the index. 

So the essential argument is that it works if you want to get the highest rate of return from equities, the best strategy is that at least the core of your portfolio ought to be in a simple, broad based, low cost index fund or exchange traded fund. And what you can do now is, particularly through some of the exchange traded funds, you can get this at essentially zero cost because the cost, the expense ratio for some of these funds are something like 2 or 3 basis points, 2 or 3 hundreds of 1%. So essentially zero cost, at least the core of your portfolio ought to be in these index funds. So that's the thesis. And by god, it works.