Who Wins—Active or Passive Investors?

The Investment Race

Many retirees invest passively by buying shares in low-cost index funds that are designed to track selected markets. I have illustrated that approach in previous posts.

Many other retirees, and many younger investors, actively manage their investments. Some retirees do their own research and analyses while others hire brokers, financial planners or other advisers to manage their investments. They hope to achieve superior performance—to beat the market—by relying on extra effort, knowledge and skill. 

Applying effort, knowledge and skill to achieve superior performance works with most of life’s activities: we become better parents, employees and hobbyists by applying them. We use the same thinking when hiring others—doctors, lawyers, plumbers, teachers and many others. Most of us would say that hiring on those criteria is just common sense.

Unfortunately the idea of trusting skilled professionals usually does not work well for investors. Active investors on average earn less money than their passive contemporaries because both experience the same gross return but active management costs more.

The Logic

In 1991, William F. Sharpe, a Nobel winner in economics, published a short but incisive article on Active Management. He states his conclusions early in the article, saying:

… it must [original italics] be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Active investors are those who look for stocks or other investments that are mispriced—stocks that are lower or higher than their true values. Such investors believe they can reliably find mispriced stocks, or sometimes that they can find superior mutual funds run by people who are themselves good stock pickers. Whether working on their own or through advisers or fund managers, an active investor’s goal is always to predict stock prices so they can buy before stocks rise and sell before they fall.

Alternatively, writes Sharpe, “A passive investor holds every security from the market, with each represented in the same manner as in the market.”  In practice, most passive investors hold index funds that use a sampling procedure to decide how many and which stocks to hold. Modern index funds tend to closely track their parent markets even though they don’t hold every eligible stock.

Sharpe reasons that the the total market is made of up passive and active investors. Passive investors will match the market, provided their index funds accurately track the market.

Since the total market is composed of passive and active investors, if the passive investors match the market, then the active investors must on average also match the market. The logic is inexorable. If two groups compose a market, and if the average performance of one group matches the market, then the other must also match the market.

Once costs are included—advisers, trading, active mutual fund management, any front or rear sales charges—the performance of passive investors will win. Active investing definitely involves higher costs.

Passive Investor: resting, watching and winning

The analysis says nothing about variance, but it must be true that active investors will have more widely varying returns than passive investors, whose returns will almost uniformly match the market. With some active managers winning, it is easy to create the notion that you too can be among that group. Unfortunately, that group is impossible to know in advance, and its members change frequently, leaving few if any consistent winners.

Why?

Sharpe’s small article is a matter of pure logic and is difficult to refute. Still, readers may yearn for more reasons. Why are investments so different from other areas of human endeavor, where knowledge, skill and effort pay such large dividends?

The answer is that modern stock markets are efficient—at any given time, they have built into their prices all of the known information about the various stocks. There are many smart people involved in gathering and sharing information about stocks.

This efficiency leads, in the short run, to stock price movements that are random walks—there are no known relationships between past and future stock prices. For individual stocks or for entire markets, there are no reliable methods for predicting daily, weekly, monthly, or yearly stock prices.

There are many supporters of this view and much evidence from studies of stock price behavior. One of the best discussions of these ideas is presented in the highly regarded, “A Random Walk Down Wall Street,” by Burton G. Malkiel (NY: W.W. Norton & Company, 2011). He sums up the conflict between active and passive investment as follows:

The view of most investment managers is that professionals certainly outperform all amateur and casual investors in managing money. Much of the academic community, on the other hand, believes that professionally managed investment portfolios cannot outperform randomly selected portfolios of stocks with equivalent risk characteristics. Random walkers claim that the stock market adjusts so quickly to new information that amateurs buying at current prices can do just as well as the pros. Thus, the value of professional stock pickers’ advice is nil. (189)

In the next paragraph, Malkiel says, “Although it is abundantly clear that the pros do not consistently beat the averages, I must admit that [a few exceptions to the rule exist].” The exceptions are bubbles or other instances where crowd psychology shapes markets for short periods. Although there are exceptional financial managers like Warren Buffett or Peter Lynch, “they are very rare, and there is no way of telling in advance who they will be.”

Both Buffett and Lynch have “admitted that most investors would be better off in an index fund … ” (188)

Malkiel concludes that markets are efficient—that relevant information about company prospects is incorporated so quickly into stock prices that individual investors and their managers are unable to consistently gain an advantage by studying firm or market prospects (188, 190-191).

This does not mean all is lost. Although short-term stock prices behave randomly, long-term stock prices tend to rise with earnings and dividends. That too has been amply demonstrated.

A retiree’s best bet then, is to buy index funds that closely match their respective markets and that offer very low costs. Those retirees will will ride the long-term economic forces to gradual increases while spending most of their time on other pursuits. Fund and stock shopping, trading in and out, and hiring professional managers are all expensive, and net of costs, they trail passive investors.

In the next post I will use data from selected mutual funds to show the difference in performance between active and passive investment. The superiority of passive investing is surprisingly large over your retirement life.