Passive investing (ideally) is simply investing in proportion to the total market. Active investing is being invested in some other way. Usually active investing is done in an attempt to do better than the total market return by buying the things that are going to go up and selling the ones that are going to go down. But people can be active investors without realising it, for example, investing in a single country or region or even merely out of proportion to the world capital market, is a kind of active investment, since by doing so you are in effect hoping that the bits you are investing in are going to do better than the bits you aren’t invested in. Most people are currently active in both ways since they are invested in a managed fund rather than a passive index and are entirely invested in(Popular summaries of the ideas behind the rationale and the research lying behind those ideas can be found in, for example, Bernstein Capital Ideas, Bogle Common Sense on Mutual Funds,
their own country's stock exchange.
First of all, ignore all trading and management costs, passive investors as a group get the total market return. So do active investors as a group. However, active investors are playing against each other a zero sum game modulo the total market return. So an important question to be able to answer if you want to invest actively is what makes you think you know enough to be on the winning rather than losing side. I don’t think I do and I will explain shortly why it is difficult to see that anyone does beyond a certain stringent limit.
Furthermore, the situation of the active investor is worse than that once we include management fees (which are usually stated as a percentage) and trading costs (which are usually not stated). Passive investors can pay very low costs: Vanguard in the US has management fees as low as 0.06%. Alas in
it is significantly more, at about 0.2% for the cheapest (Vanguard again). In passive investing there
is little turnover so the trading costs are relatively small. Active investors
typically pay in the region of 1%-5% management fees and also can pay 5% just
to join a fund. The high turnover in stocks of active investment means trading
costs are significantly higher too. I don’t know what the average is, but
suppose it is only 3%. This means that active investors as a whole are playing
a negative sum game, loss rate of 3%.
The reasons to doubt you should be an active investor are surprisingly varied and interesting. What is particularly interesting is how much of investment plays into our cognitive biases. I shall, however, focus mainly on the reason based on the nature of the asset market itself.
If you think you can choose your own stocks and shares you’ve got to think you know how to find the good ones. If you think you can hire an expert to invest for you (i.e. the manager of a fund or a stockbroker) it is really the same problem as choosing your own investments all over again. You’ve got to think you know how to find one of the good ones, as well as assume that there is expertise.
The reason to think that you don’t know and may be nobody knows is called the efficient markets hypothesis. This is widely misrepresented as the hypothesis that markets are perfect. Instead, it is the hypothesis that markets are the best estimator of the value of an asset. To some extent the hypothesis is an idealisation and simplification, and in being so it is typical of economic and other scientific theories. In the short run there can be periods of high uncertainty and high volatility when markets can appear to be poor estimators of value but if that is really right somebody should be able to beat the market at a rate better than can be explained by luck, and few appear to be able to do this.
The hypothesis has weak, medium and strong versions, relative to the information encompassed by the market price. In effect, the idea is that to beat the market (as an active investor) you’d need to know more than the specified information. The weak version implies that you can’t beat the market by knowing the price history. This rules out an investment technique known as technical analysis, on which future prices are predicted on the basis of patterns in historical prices. The medium version implies that you can’t beat the market by knowing the public accounts and other publicly available information. This version rules out an investment technique known as fundamental analysis investing. The strong version entails that there is no information available to allow you to beat the market, i.e. the price encapsulates all the information known by anyone anywhere.
The strong hypothesis is ruled out by the laws we have forbidding insider trading (a reason why those laws are criticised by some for ensuring the exact opposite of their declared intention!). There is very strong statistical evidence that the weak hypothesis is true, quite strong statistical evidence that the medium hypothesis is true, and there is also strong evidence that the medium hypothesis tweaked by value and size factors is true
How, then, do some people make billions? First of all, the wide variance in the prices of stocks and shares means that with tens of millions of people investing for themselves and tens of thousands of managers investing on their behalf there will be thousands of individuals and hundreds of investment managers who do spectacularly well every year just by chance. You’ll hear about those ones!
One sided attribution error lead people to take their successes as down to their skill and their failures down to bad luck. Availability error leads us to think there are experts because we hear of the people who did well. Some managers have good track records but, again, when economists have tried carefully to assess the whole cohort of fund managers and determine whether past performance predicted subsequent success, they generally report negative findings. For example, in the medium term less than a quarter of managed funds match the market return and the number that stay in the top quartile over a period of years is about what you’d expect by chance alone (i.e. about (1/4)n for n years).
Secondly, the EMH does not rule out inefficiency altogether but rather entails that the amount of inefficiency is constrained by what it costs to find it out and trade it away. So high transaction and information costs mean less efficiency, and vice versa. We can even estimate the inefficiency by assuming that a significant proportion of the money making we hear about is not random but trading on inefficiency. When you consider the scale of the world market and the scale of the flows of funds (in the trillions), the fact that some people you’ve heard of can make a billion, or several billions, only amounts to the market prices being inefficient in the region of 0.1% on average. Of course, that inefficiency may be concentrated but EMH says the market will pay just enough for enough people to find and eliminate those inefficiencies. This, by the way, is another reason to be a passive investor: in effect any active investors who do know what they are doing and make money by trading and thereby removing inefficiencies are working for you as well as themselves.
Another objection made is that the high volatility of stock markets proves they are inefficient. This is based on wishful thinking and ignorance of the sheer size and complexity of the world economy, how dynamic it is, how large the factor of chance is in commercial success and how little anyone (even the managers) can know of what is going on in a company and how and why it survives. Success is sometimes excellence but it can turn out that excellence is what it takes to make less of a mess of it than your competitors. Who ever thought General Motors would go bust? It appears that far from large companies having the power to dominate their markets and ensure their persistence, they go bust all the time. I don’t remember the exact figures but something like less than 10 of 100 the largest companies in existence 70 years ago still exist.
When EMH says market price is best estimator, being best here needn’t be very good. One of the most committed proponents of EMH, Fisher Black of the Black-Scholes equation, took EMH to mean the market price was between half and twice the value of a stock! When you say that, it sounds like you should be able to beat the market, but as already mentioned the evidence shows otherwise and this spread also partly explains why significant numbers of people can do well by luck.
Furthermore, we don’t like risk and chance and suffer from the delusion they can be got rid of entirely rather than shifted around at various costs. What happens is that they get concentrated in the asset markets by our willingness to pay for them to be removed from elsewhere and also by the laws we pass that actually focus risk on companies. For example, job security has a cost in company survival: more companies go bust than would otherwise do so if they could sack anyone at will. I’m not saying that isn’t a cost worth bearing but it is still a cost and because of that cost the risk hasn’t been got rid of, it has just been transferred. So given the underlying chanciness of life and our desire to shift the risk, we should expect markets to be highly volatile. That being said, the volatility does, I think, mean that the right way to get a lump sum invested is to spread it in regular amounts over 6 months to a year. There is evidence, however, that this is wrong, and that about 2/3rds of the time investing all of a lump sum immediately will do better that spreading it out.
So I don’t know how to find better investments than simply investing in everything, I don’t know how to find the people who do know and I don’t know if the people who appear to know really do know or are just lucky for a long time. I don’t believe the people who claim to know really do know and I don’t believe the people who claim to know enough to outweigh what they will charge to manage your investments for a fee either. If you are ignorant they may save you from making some mistakes. But we are not merely ignorant, we are better than that. We also know we are ignorant and doubting for excellent reason that anyone else knows much better we pursue the investment strategy that makes sense given ignorance. For these reasons I think we should invest our savings in everything.
Can be done by the use of Vanguard mutual or exchange traded funds, although for bonds and real estate one may need to use Ishares exchange traded funds. In all cases invest only in funds that invest in what are called physical index securities, by which they mean the fund possesses the actual shares and bonds of the index. Specifically reject investing in exchange traded funds, such as those by Deutsche Bank db x-trackers, which are called index exchange traded funds but are in fact financial derivatives. Such funds are merely a promise by the bank to trade and pay out in accord with an index. They depend ultimately on the solvency of the bank alone. By contrast, the funds that invest in what are called physical index securities depend ultimately on the solvency of the hundreds or thousands of companies whose shares and bonds are owned by the fund.
The reason for using Vanguard and Ishares is that since passive investments in funds that index a market are much the same you should go for the cheapest such funds. Vanguard are the cheapest we know of and being a mutual company the profits from managing their funds are fed back into the funds.
In general do not trade investments but simply hold them. Trade investments for the following three reasons
1. Rebalancing our investments to keep them in line with our target asset allocation.
2. Investing surplus cash.
Allocation of assets
Basic allocation question: what percentage to put into stocks, bonds and real estate?