Or another way to ask the same question is: Can you get a higher return by actively investing?
Well I think, it depends :)
I guess markets are mostly efficient at least as far as an individual investors are concerned. Unless you have plenty of time to devote to markets and researching individual stocks you will find it difficult to beat the markets
If you look really hard for it then you will be able to find stocks that are under-priced and consequently make a higher return. But the question remains, does the return justify the time invested and the amount of risk you will bear to hold the position in the stock.
Consider for an individual investor to build a diversified portfolio he should not hold more than 3 to 5% in one single stock. So that implies having around 20 to 35 stocks. This is too much work and transactions costs will be very high for the amount of money that will be invested. Investing in an index will just be easier and cheaper. If you are not diversified and hold 5 to 10% of your portfolio in 1 stock then 1 Satyam / Enron can wipe out your entire gains.
If you are high net-worth individual (HNI) or an institutional investor then you have lot more opportunities available to hedge risky stocks. You could write options, buy protective puts, delta hedge etc. These are generally used to manage risks in a well diversified portfolio and will be very expensive for a small investor.
So, if markets are reasonably efficient then what is the best strategy for an individual investor. Is it enough to just put all your money in an index fund? What other things can we do to get better returns?
Over the next several posts I will be looking into what a small investor can do.