Nothing in the economic corner of our culture elicits more collective fascination than the stock market. Media attention, conventional wisdom, parental advice, folklore, and scandal all seem to work overtime when it comes to “the market.” U.S. equity markets at the dawn of the twenty-first century are unique in terms of the broad participation of individual citizens—both the wealthy and middle class.
More than 50 percent of American households now have direct or fund-based holdings in stocks. Corporations continue to move away from the defined benefit pension plans of our parents toward defined contribution systems in which individuals make critical long-term investment choices. The standard of living while in retirement for a large segment of the U.S. population now depends on how people choose to invest.
Individual investors face a number of important strategic investment decisions, including basic asset allocation—how much of their total portfolio to put in stocks. The growing availability of low-cost equity index funds introduces another strategic decision: whether to invest actively or passively.
Active investing is broadly defined as the process of researching and picking the best stocks to buy, or hiring a professional fund manager to do it for you. Implicit in this process is the assumption that some stocks are better holdings than others and that a diligent search can ferret them out. Indexing or passive investing presents an increasingly popular alternative to active investing. Index-funds include all stocks in proportion to their capitalization in the market. All stocks in the target market are included—there is no attempt to distinguish between good and bad investments.
Active and Passive Strategies
Active or passive? In most of life’s endeavors the answer is pretty obvious. When did you last read a self-help article extolling the virtues of a passive personality, or a professional article advocating a passive approach to your business affairs? However, the logic and arguments for passive investing are less obvious.
To make matters more complicated, professional advisors and financial market pundits have little incentive to promote the passive alternative in the investment management debate. The rare voices of passive advocates such as Newsweek’s Jane Bryant Quinn and The Wall Street Journal’s Jonathan Clements are often drowned out by the sincere but potentially biased advice of brokers, fund managers, commission-based financial planners, online trading firms, stock exchanges, and the financial media who sell advertising time to all of the above. These groups all make less money when an investor chooses to index. With this anti-indexing bias in mind, the following two arguments present the pro-indexing, or passive position.
Arguing Efficiency
The most common argument for passive investing is that stock prices in highly liquid and well-regulated markets are informationally efficient. Economists who study the effects of competition in financial markets theorize that all stocks will have a “fair” price that moves in tandem with relevant information. Economic theory defines the fair price as the best possible estimate of the per-share value of the corporation. Fair does not mean the correct price after the fact—just the best possible guess one can make from the available data. If a particular stock is underpriced, diligent investors will initiate buy orders that will quickly push the price up to its fair value. Similarly, the selling of overpriced stocks by informed market participants will pull the price down.
The controversial Efficient Market Hypothesis concludes that there is no point to security analysis because any stock is priced as well as it can be. Unusual performance, good or bad, is purely a matter of luck. Active buying and selling of stocks by individuals will only run up brokerage commissions and waste time and energy. Turning to a professionally managed mutual fund is even worse, according to the hypothesis, because of the fees required to pay well-compensated experts to waste their time in an environment where the outcome is a mostly a matter of luck.
Try this line of reasoning next time you talk to your broker or active fund manager. You’ll either get stunned silence, as in, “What kind of economic mumbo-jumbo is that?” or, hopefully, a well-thought-out counterargument. Opponents of the Efficient Market Hypothesis note that this academically fashionable idea is based on the premise that people are “rational utility-maximizing agents.” If you have had any firsthand experience with people (or happen to be a person yourself), the assertion that people are rational may be a bit difficult to swallow. In fact, the growing economic discipline of behavioral finance is based on the proposition that investors are predictably irrational.
For example, stock markets might be persistently inefficient because many participants continue to confuse a good company with a good investment. As any experienced investor knows, if other investors already anticipate a highly profitable company’s future, the stock price will reflect that belief and the return to new investors will be mediocre at best. Other human frailties, like the tendency to place too much weight on the most recent data, may cause investors, and thus market prices, to overreact to news. Predictable overreaction allows for a market timing strategy of buying on bad news—purchasing stocks whose prices have recently dropped.
Another assertion is that all but a few investors neglect certain obscure stocks. This assertion motivates momentum strategies: buying stocks whose prices have started to rise. If investor irrationality—in the form of exuberance, fear, or ignorance—is pervasive enough, stocks will sometimes be mispriced and the market inefficient.
At this point, the true-blue efficient market theorist may start backpedaling and admit that many investors may be irrational, but there are probably enough level heads to eliminate stock mispricing when it occurs. The proportion of rational market players needed to make the market efficient isn’t clear; it may not even require a majority. “More economic mumbo-jumbo!” responds the broker or active fund manager. “Capitalism is based on rugged individualism, hard-earned knowledge, and market research—the spirit of entrepreneurship! Someone has to be the first to detect the mispricing of a stock and take advantage of it. Why not me?”
At this point, the market theorist is likely to backpedal a bit more and admit there may be some mispricing in the stock market after all. But the marginal benefits of good research are probably no greater than the marginal costs. And since we have brought up capitalism, he or she might also point out that an efficient equity market is actually an assumed prerequisite. Fair security prices promote social welfare in our economic system by ensuring that capital is allocated to its best and highest use. As Rex Sinquefield only half-jokingly proclaimed: “I’ve polled everyone I know, and the only people who think that markets are not efficient are the Cubans, the North Koreans, and the active fund managers.”1
This efficient markets debate is entertaining, but in the end few individual investors understand or buy into the efficient markets argument. The invisible hand in financial markets is just too hard to see. One could cite an endless array of statistical studies of stock market efficiency—possibly the most empirically researched question in all of economics. The hard evidence indicates that the stock market is reasonably efficient; fund returns in excess of the general market from period to period are almost wholly, although not completely, random.
Active management performance is mostly, although not entirely, a function of luck. However, the debate may be moot. As it turns out, the Efficient Market Hypothesis is neither the most straightforward nor the most convincing argument for indexing.
Arguing a Zero-Sum Game
Assuming that the stock market is not efficient, should you be an active investor? If stocks are occasionally mispriced, someone with the skill and expertise required to identify the inefficiencies might do well. Consider other skill-based activities—a free-throw competition in basketball, for example. Suppose that you get a dollar for every shot out of ten that goes through the basket, and there is no fee to play. This is a conservative assumption with regard to the stock market because there are “fees” to
active investing, like transaction costs and tax inefficiencies.
Like any analogy, the free-throw competition has its strengths and weaknesses, but one important characteristic of this analogy is that most players in the game will make at least some money. This is a critical characteristic, because the stock market is a “positive-sum” game in the sense that investors do, on average, enjoy returns greater than the time-value of their money or interest rates. In contrast, sports betting and other forms of gambling are “zero-sum” games.2 A zero-sum game is one in which the profits of all players sum to zero.
Under the no-fee-to-play condition, you should play the free-throw game—and trade actively in the stock market—even if your self-assessed basketball talent is marginal. But what if we add a twist? Instead of actively participating in the game, you can take the average score of those who do. Passive investing is just such a twist in the investing game because a total-market index fund contains all stocks, and all stocks have to be held by someone.
This often ignored but unassailable fact has important implications. Chief among them is that before accounting for the costs of active investing, the market index return over any time period is equal to the average performance of all investors during that time period. The index used must be a total market index, and the average investor performance must be calculated on a dollar-weighted basis, but these are technical details. The important point is we have met the market and the market is us—the collection of all individual and institutional investors.
While investing is a positive-sum game, active investing is a zero-sum game with respect to the alternative of indexing. Your ability to outperform the indexing alternative—be better than average—depends on someone else being below average. Someone has to buy the stock you want to unload at a higher than justified price, and sell the stock you want to buy at a bargain. Don’t believe the financial media when they suggest that everyone is selling a certain stock. On any given day, there are exactly as many shares bought as sold.
The fact that half of all returns have to be below the average return seems pretty straightforward, but what about all the other considerations that market observers seem to ignore, like transaction costs, taxes, and risk?
Although transaction costs are low and getting lower all the time, thanks to online trading and the decimalization of price quotes, the point remains that active investors trade more than passive investors, so transaction cost considerations will always favor indexing.
Taxes? Passive management is tax-efficient compared to active investing because the IRS defines a trade as a taxable event. Outside of tax-deferred accounts, such as 401ks and IRAs, capital-gains taxes are due every year as stocks are bought and sold under active management. Indexing defers capital-gains taxes until the investment is liquidated for consumption purposes during retirement.
Risk? William Sharpe received the 1990 Nobel Prize in economics for proving, among other things, that the only perfectly diversified portfolio is the capitalization-weighted portfolio of all stocks. Anything less exposes the investor to diversifiable risk that he or she could have avoided. As a practical matter, thirty stocks is probably adequate diversification. But it’s hard to argue that an active fund with a few stocks is less risky than an index fund with all stocks.
Transaction costs, taxes, and risk considerations all seem to favor indexing. Still, the most significant “cost” to active investing compared to indexing may be research time and effort. Successful investors know that identifying the best stocks to buy requires substantial time analyzing the large amount of data available on thousands of individual stocks, including financial statements, market trends, management competence, and industry structure. When investors hire out these research activities by buying professionally managed mutual funds, they typically pay fees of 1 to 2 percent of money under management. Full-service brokers charge similar fees for stock picking advice through higher commissions.
Back to the basketball free-throw analogy, there are a lot of costs—transaction costs, taxes, risk, and research and management fees—to shooting the ball instead of watching the game and taking the average. Using conservative estimates of all active investing costs, one has to be in the top 30, not just the top 50 percent, of all investors in order for active management to pay off. If we could tabulate the performance of all individual and institutional investors, we would find that about two-thirds underperform total market index funds each year. There never has been and never will be a year when more than half of all active investors outperform the market-wide index. There never has been or will be a year when more than half of all NBA teams have a winning season. Both claims are mathematically impossible.
So if the market is inefficient, active investment management can pay off, but only for a minority of investors. To be in that minority you must have lower transaction costs, better information, more accurate valuation techniques, more regulatory freedom, or some other competitive advantage. One can easily identify the competitive advantage of true insiders. Arguments could also be made about the competitive advantages for some institutional investors, including hedge funds, pension funds, investment banks and their wealthy clients, and perhaps even mutual funds.
Identifying a competitive advantage that individuals have in the marketwide investing game is very difficult. For example, the assertion that there are other small investors who are even less sophisticated than oneself ignores the fact that nonwealthy investors as a group comprise only a small fraction of the total market—about 10 percent in terms of dollars invested.
Mutual funds that invest on behalf of nonwealthy individuals comprise another 15 percent of the market. Thus, to earn higher-than-average returns and beat the index, one has to outperform much more than individual investors and mutual fund managers.
Conclusion
The logic for indexing is even more persuasive if you believe the stock market is inefficient. If the stock market is inefficient and active investing
is a skill-based activity, then individual investors who try to actively manage
their portfolios will consistently lose to professional players with competitive advantages.
Although shooting hoops may be fun, if there are professional players on the floor, simply watching the game and taking the average score will almost always earn you more points.
END NOTES
- Rex Sinquefield, Schwab Institutional Conference, San Francisco, 12 October 1995.
- The zero-sum game logic and other analogies in this article are not meant to suggest that active investing is morally equivalent to gambling. The important but sometimes subtle distinctions between legitimate investment management and gambling from an LDS perspective are discussed with all business students as part of the ethics curriculum. Active management expertise and valuation strategies are routinely taught to students who seek employment in the financial sector.
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By Steven R. Thorley
Illustrations by Nicholas Wilton
About the Author
Steven R. Thorley is a professor of finance at the Marriott School and a Chartered Financial Analyst. He has published numerous articles on financial markets and investing in both academic and professional journals. His research has been presented at academic and professional seminars around the world and is frequently cited in The Wall Street Journal and other major financial publications.
Thorley earned his BS in mathematics in 1979 and MBA in 1982 from BYU and his PhD in financial economics in 1991 from the University of Washington. He recently returned to the Marriott School from academic leave as the interim research director for Analytic Investors in Los Angeles.
