“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson
In most areas of life, the harder you work, the better your results should be. Similarly, the quicker you make decisions and actions, the more you should be able to accomplish. Investing seems to be one of those rare spaces where patience outperforms being reactive and where years of in-depth research can be out-matched by simple investing rules. This counter-intuitive nature of investing is at the foundation of the debate between active and passive investing.
Some argue that if your investment returns are above average, you need to pay an elite-educated stock-picking guru who will use their skills to pick the best investments for you (active management). However, research suggests that monkeys perform better than an elite education.
Princeton’s Burton Malkiel claimed in A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
Rob Arnott, CEO of Research Affiliates, stated that “Malkiel was wrong. The monkeys have done a much better job than both the experts and the stock market.”
In 2007, Warren Buffett made a $1M wager with Protégé Partners that the S&P 500 index fund (passive management) would outperform a basket of hedge funds (active management) over the next 10 years. The index fund returned 7.1% a year (compounded annually). The hedge funds returned 2.2% a year, not even close. Mr. Buffett gave his winnings to the nonprofit Girls, Inc. of Omaha.
So, what exactly is an index fund?
An index fund follows set, predefined rules of investment. The fund manager essentially runs a screen on the investment universe, and whatever passes the screen, they invest in. No research is required; thus, fees are typically much lower than active funds.
The most famous index fund is the S&P 500. The screen is simple. Invest in the stocks of the 500 largest companies in the US proportionately to their relative sizes.
There is no debate about whether Apple is better than Google or if Verizon is better than Sprint. An S&P 500 index fund buys the 500 largest companies proportionately. It’s a screener, not an in-depth research project.
Since most US stock markets consist of these large companies, investing in an S&P 500 fund (like SPY) will get you invested in about 80% of the US stock market. When investors say they are buying the market, they mean buying most of the stock market through an index fund, usually implying the United States stock market, and usually means an S&P 500 fund like SPY.
If index funds are better, shouldn’t we all invest in those?
Not so fast. At a high level, five major investment asset classes include stocks in small companies (U.S. or developed countries), stocks in large companies (the U.S./developed), stocks in emerging countries, bonds from companies, and bonds from governments or institutions. Investors talk about how efficient a particular market is, how public and easy it is to obtain information on a particular security and act on it.
Generally speaking, the stock market is more efficient than the bond market. Developed country stocks are more efficient than emerging market stocks. Large-cap stocks are more efficient than small-cap stocks.
On average, active managers outperform passive strategies in inefficient markets, where their research and skill can give them an edge. Similarly, in efficient markets, it becomes more difficult for active managers to outperform an index. However, some active managers have performed quite well over long periods of time, even in efficient markets.
This is why we recommend using a combination of both active and passive strategies. The Means philosophy is to use well-diversified strategies and never overreact to market volatility. Since 1935, our belief in patience and discipline has paid off for our investors. Successful investing is our goal, not an adrenaline rush.
The debate between active and passive investing will continue. At Means Wealth Management, we follow the latest research to ensure your portfolio is diversified and well-positioned to succeed. We strive to stay on top of the latest research, so you don’t have to. We do the financial planning and investment management that we love, so you are free to do the things you love. As always, if you have any questions, please let us know.