Active Versus Passive Investing

This an excerpt from How to Invest Wisely. To purchase the book, click here.

The Latin root of the word to speculate means “to see.” A speculator is someone who presumes to see something that is not yet evident in the market price of the object of speculation.

Some hope to find clues to future stock prices by studying past stock prices. Others pore over statistics and financial reports in hopes of forecasting economic trends and how they will affect stock prices in general or the fortunes of a given company in particular. Analysts, investment managers, and individual investors scrutinize such studies as well as corporate reports and filings with the Securities and Exchange Commission. They also study anything else that might be seen as an influence on the trends of market prices for securities, such as the weather or even sunspots.

Many newspapers, magazines, and newsletters are largely devoted to such topics. Cable TV channels parade experts pronouncing on the latest news and developments, which are then chewed over in chat rooms and bulletin boards on the Internet. Brokerage firms, fund managers, investment advisors, and institutional investors probably carry out the weightiest analyses, mainly for their own use. Such efforts are designed to facilitate active investing, in which all purchasers and sellers believe that they have some knowledge that is not yet fully reflected in the prices of the securities that they are buying or selling.

Every recommendation concerning a specific security is an implicit assertion that the current market price is not an accurate reflection of the prospective returns and risk of that security; in other words, that the market somehow has the price wrong. As a wag once observed, there are three places in the world where people continue to believe that markets do not work: Cuba, North Korea, and Wall Street!

Efficient Markets and Random Walks

But what if prices, on average, do reflect potential returns and risks with accuracy? What if the activity of all market participants does produce valuations that more accurately reflect potential returns and risks than that of a single buyer or seller or analyst? If this is the situation, then prices will only change to reflect new or additional information, which will be inherently unpredictable. As a consequence, security prices will move in what statisticians call a random walk—that is, the most recent price quote is the best predictor of the next transaction.

This view, often called the efficient market hypothesis, is anathema to investment professionals. Clearly, the professionals assert, some investments perform better than others; and, by determining the factors that account for these divergences, one should be able to select advantageous investments.

Given the infinite range of possibilities, some recommendations and predictions are bound to be successful in a given time period. Those whose picks do exceptionally well quickly acquire a following that drifts away once others begin to do better. But this is mainly a statistical phenomenon.

If 1,000 persons selected at random from a telephone directory were asked to pick five stocks that will be attractive holdings for the year ahead (companies with stocks that are underpriced relative to others), there will be a wide dispersion of results. Most of the selections of five stocks each will fall relatively close to average. But there will be a few outliers that have drastically underperformed or outperformed the average. There is little reason to believe that, at any one time, the current Wall Street superstars are benefiting from something other than this phenomenon. The fact is that a majority of professional recommendations are mediocre.

Index funds

There is little reason to believe that the relative performance of a given advisor or fund manager in one period will be maintained in a subsequent period. As they say in the prospectuses, “past performance is not predictive of future performance.” (The exceptions probably include those who charge their customers exceptionally high fees. They are very likely to underperform consistently) A mutual fund purchaser, in particular, cannot reasonably expect to do better than the S&P 500 index. Buying a fund that did better than the S&P 500 over the past 10 years does not give one a better-than-average chance of doing better than the S&P 500 over the next 10 years.

Included in the Morningstar database of domestic common-stock funds are several dozen funds designed to track the S&P 500 index. Most of the differences in the returns are explained by differences in expenses. The lowest cost funds typically achieve returns that are close to the returns on the index.

A majority of those who purchase actively managed domestic common- stock mutual funds would be better off purchasing one of the S&P 500 funds instead. An investor is equally likely to be better off holding an easily purchased low-expense mutual fund tracking the S&P 500 index than by holding one of the thousands of mutual funds that are managed by stock pickers.

Up From Stock Picking

The approach we are suggesting is based on the notion that attempting to determine which stocks or industries will thrive or which fund manager will have a hot hand is a fools’ errand. Moreover, an actively managed fund may not follow a consistent investment strategy or policy. Fund managers who strive to pick “the best stocks” can change their minds. They also may attempt to time the market (adjust their holdings according to a forecast of broad trends). The managers themselves can change. This means that you may not know when a fund that was purchased to serve a particular function in your portfolio is no longer serving that purpose because of a change in the fund’s approach or management.

Buying an S&P 500 index fund as a way of investing in domestic common stocks would be a move toward a passive investment strategy that for most investors will perform better than their “informed” choices of common stocks. The stocks in the S&P 500 index are by definition large-capitalization is- sues. During the 10 years that ended in 2009, the S&P 500 underperformed on average the stocks of companies whose market capitalizations were too small to place them in the top 500. The index of the total market value of the next 2,500 companies returned 4.9 percent during the period compared to minus 1 percent for the S&P 500. This means that passive investors should find additional vehicles to participate in the wider market.

Read more excerpts from How to Invest Wisely:
As You Prepare to Invest
Active Versus Passive Investing
Why Most Investors Fail
The High-Yield Dow Stock Selection Strategy