An active investor buys securities that he or she thinks will increase in value. Investment decisions may be based on a multitude of factors, including but not limited to financial analysis, predictions of a company's future success, Magic Eight-Balls, and Ouija boards.
A passive investor buys everything in an index. An index represents all of the securities available in a defined arena. For example, the S&P500 index consists of the 500 largest U.S. companies by capitalization size (i.e., number of shares, times price per share). Indices are typically “market-weighted,” which means there will be more shares of a larger company in the index than that of a smaller company.
The reason that the best and brightest students aspire to work in the largest investment firms is active management. That's where the money is. Managers can charge a premium for their stock-picking “skill,” so they often earn high fees for the promise of higher returns to the investor.
Because an index manager only follows the index, with no judgments as to “good” or “bad” stocks, you only pay for the commodity service of the manager buying, holding, and rebalancing a basket of securities. There is no premium for a manager's perceived expertise. That's why index investing is an inexpensive and effective way of achieving ”average” returns.
Why be Average?
We are taught from a young age that being average is not desirable. Yet, in investing, “average” is a reasonable compromise for a couple of reasons – (1) the quest for above-average performance, more often than not, results in below-average performance and (2) the “house” (i.e., Wall Street) makes more money on active management whether you win or lose.
1) The Efficiency of Markets
Modern Portfolio Theory (MPT) teaches us that markets are efficient, meaning that it's difficult to outsmart all of the smart active management investors who are trying to determine a stock's intrinsic (i.e., “true”) value. An investor who perceives that a stock is underpriced will buy it, expecting that it will eventually rise to be equal to its intrinsic value. Herein lies the leap of faith – the investor must believe that he or she has peculiar insights to the rest of the market. If a stock is trading for $40 a share, and the investor thinks it's worth $50, he'll buy it and hope that it rises to $50. But he's betting against all of the people who think it's worth $40.
Occasionally, an investor will identify a legitimate price mismatch and make money from it. That's why it's appropriate to say that markets are fairly efficient. Active management is a tough game. Successes are difficult to come by. How difficult? Well, virtually every study on this topic reaches the same conclusion – more than half of active managers, including mutual funds, do not beat their benchmark.
A benchmark is a measuring stick that defines whether performance is above average, average, or below average. For a manager who trades in large cap stocks (i.e., large companies), a typical benchmark would be the S&P500. More than fifty percent – perhaps as high as eighty percent, depending on the study – have investment returns (after fees are deducted) that are below those of the S&P500 index. That means you could invest in the index and earn greater returns with less risk.
Some markets are more efficient than others. Generally, large cap markets tend to be the most efficient with small cap markets being less efficient. The theory goes that there is less known about smaller companies because fewer analysts follow them; therefore, an analyst can identify a price mismatch by skillfully assessing a company's financial performance and future prospects. When many different analysts are doing the same thing, it's difficult for one analyst to prevail with superior insight.
The idea that active managers struggle to beat their benchmarks is not a new concept. In 1973, Burton G. Malkiel of Princeton first published his classic book, A Random Walk Down Wall Street. In it, Professor Malkiel proposed that a chimpanzee throwing darts at the financial pages of the Wall Street Journal could achieve better returns than most professional money managers. It's still true.
"Active management is a beauty contest in which the average contestant is kind of ugly."
-- John Rekenthaler, Research Director, Morningstar
"I'd compare stock pickers to astrologers, but I don't want to bad-mouth astrologers."
-- Professor Eugene F. Fama, University of Chicago, Fortune, July 6, 1998
2) When You Play by the “House” Rules, the “House” Wins
Consider this scenario. A Las Vegas casino entices you to visit by guaranteeing that you'll break even at the end of your visit. Would you take the bait? Probably not, because you gamble for two reasons – (1) recreation and (2) the promise of easy money. After all, what fun would it be if you knew you couldn't win or lose?
So it goes with index investing. You are guaranteed “market returns” and nothing more. You are betting that a disciplined program of investing over the long-term will eventually build a nest egg that will allow you a worry-free retirement. There are no home runs and no strikeouts – only singles and doubles.
Why is this “average” performance better for investing than for gambling (or “gaming” as the industry would prefer to call it)? Hey, this isn't recreation, folks. This is your savings and retirement security that we're talking about. Average is good. If it's not already obvious to you, investing is not supposed to be gambling.
As for the natural human desire to gamble, that's a topic for another day!
“Sometimes the bears win, and sometimes the bulls win, but the pigs always lose."
-- Morgan Shipman, Law Professor, Ohio State University College of Law, 1984
"Buy an index fund or stay out of the market. Period."
-- UCLA professor Schlomo Benartzi, InvestmentNews, December 14, 1998
"Indexing is a marvelous technique. I wasn't a true believer. I was just an ignoramus. Now I am a convert. Indexing is an extraordinary, sophisticated thing to do...If people want excitement, they should go to the racetrack or play the lottery."
-- Douglas Dial, CREF Stock Account Fund
Next up: Shouldn't I hire a professional to do my investing?