On Passive versus Active Investing

In the investment community, it is common knowledge that actively managed investment funds typically underperform in comparison to popular market benchmarks like the S&P 500. Investment professionals who spend their full-time job trying to beat the market usually can't. So why do individual investors think they can when doing it part-time?

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First things first, let’s quickly glance at the difference between active and passive investing. Active investing is what the typical wolf of wall street does. He has a portfolio of stocks, of which he thinks they will outperform the market by a huge margin. He times the market and tries to buy and sell at the right time. You can imagine that this requires work and skill. You need to stay updated on current market conditions, and more importantly, have a supernatural gift to pick exactly those stocks that outperform the market. Because of his supernatural gift, he earns a seven-figures salary and lives a fast-paced, drug-and-woman fueled lifestyle. Of course, I’m exaggerating here. The typical mutual fund or hedge fund manager is not a wolf of wall street who is doing drugs all the time and flying helicopters everywhere. Instead, he (or she) is typically an ivy-league educated professional portfolio manager, who spends his/her entire workday attempting to outperform the stock market. A passive investor on the other hand, is someone who believes that beating the market is extremely hard (if not impossible). Therefore, he/she chooses to accept the market return, by investing in broad-based index funds or ETF’s that replicate market performance.

Popular media and movies often paint a picture of the typical investor as being a fast-life wolf of wall street kind of guy.

Typically, people don’t even know what passive investing is. Moreover, they have a misconception that investing is all about picking the right stocks at the right time, which is something only professionals can do. But what if I told you that according to a 2020 report[1], nearly 90% of actively managed investment funds fail to beat the market over a 15-year period? When writing my master thesis, I investigated whether it was possible to use artificial intelligence techniques to generate an investing strategy that could outperform the market. To this end, I read plenty of science about finance and investing. Time[2] and time[3] again, I stumbled upon the remarkable finding that most actively managed funds under-perform compared to the market as a whole. If even professional investors cannot outperform the market, why should you?

According to a 2020 report, over a 15-year period, nearly 90% of actively managed investment funds failed to beat the market.

This is the main reason why I believe in passive investing. Many investors, myself included, have had a portfolio of single stocks in an attempt to beat the markets. If you are doing it with “fun money” that you can afford to lose, that’s OK. But it’s not a good plan for most assets and investment goals. After all, if full-time investment professionals can’t be the market, it’s unlikely us part-timers will consistently outperform. Just last year, passive funds reached a higher asset total than active funds. This is evidence that most people understand that passive funds are the right place for the bulk of their assets. But that doesn’t seem to be stopping millions of investors from taking on risky positions in an attempt to outperform the markets. The stock market can be very exciting. Movies like the Wolf of Wall Street show a side of the market that can make people very rich, but in reality, most people won’t be bringing in seven-figures with a complex investment strategy. And, spoiler alert, the main characters in those movies ended up in prison. For most people, a long-term focus is the best way to invest. Picking a portfolio of low-cost, diverse index funds should treat you well over time. You may be able to squeeze out a slightly better return picking single stocks, but if the pros can’t do it consistently, most of us probably can’t either.

 

Yme van der Linden – February 6, 2022

 

[1] https://www.ifa.com/articles/despite_brief_reprieve_2018_spiva_report_reveals_active_funds_fail_dent_indexing_lead_-_works/
[2] Malkiel, B. G. (1995). Returns from investing in equity mutual funds 1971 to 1991. The Journal of finance50(2), 549-572.
[3] Jensen, M. C. (1968). The performance of mutual funds in the period 1945-1964. The Journal of finance23(2), 389-416.
[4] https://www.ft.com/content/27b5e047-5080-4ebb-b02a-0bf4a3b9bc08

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