Passive is the New Aggressive (Part 1)

Key Points

  • According to theory, on a forward-looking basis, stocks are priced such that each stock should offer its investors with the same risk-adjusted return as any other stock, irrespective of past performance.
  • Based upon this line of reasoning, outperforming the market is exceedingly challenging.
  • Given this, passive investing aims to keep investment choices to a minimum with the goal of selecting an appropriate benchmark and aligning investments as closely as possible to said benchmark, with minimal fees and cost.
  • Alternatively, active investing involves making purposeful decisions regarding the selection and timing of investments, in an effort to nevertheless outperform the market.

Quick Recap

In this series we’ll cover the two main types of investing; active and passive. And we’ll also discuss why the latter approach can provide great benefit to almost any investor.

At this point, we’ve laid out a compelling argument on the inherent benefit of Investing Forever (or rather, over long time horizons), but for a refresher, check out that series here.

I have also suggested that given the efficient nature of the financial markets, stocks are priced such that all stocks should provide investors with similar risk-adjusted returns on a go-forward basis. (Note: for a refresher on all this I highly suggest reviewing my series on the Efficient Market Hypothesis.) Essentially, in that series I suggested either of the following two alternatives have validity:

1) Either the markets are efficient, and therefore trying to pick a stock that is likely to outperform other stocks is impossible to pull off on a consistent basis. This is because the markets are governed by rational players that are able to instantly and efficiently incorporate all new information into market prices before you even have a chance of placing a trade.

2) Or the markers are inefficient, and subject to irrational swings, and therefore trying to pick a stock that is likely to outperform other stocks is also impossible to pull off on a consistent basis. This is because it’s very challenging (read: impossible) to figure out when the markets are sufficiently irrational, and more importantly, when this irrationally will go away.

I fully understand that this last sentence (in bold above) presents an extraordinary claim, and as such, I’ll need to provide extraordinary evidence to back it up, but rest assured, this topic will be covered extensively in future posts.

Deeper Insight

Nevertheless, if you look back at the performance of stocks over let’s say the last ten years, it’s evident that some stocks have done very well; while others have done quite poorly; while some have gone bankrupt and no longer even exist.

If all stocks are priced to offer similar risk-adjusted returns, why do stocks exhibit such a large divergence in performance over time? The difference lies between looking at past performance versus estimating future performance.

Looking backward, we see what really happened to companies as they all battled to outperform each other. Some companies exceed expectations by assembling the right team, and by creating the right products for the market—while others companies messed everything up. For these poor performers, their products could have been too expensive or outdated or even of poor quality. Or sometimes, some companies just have good luck, while others have bad luck. Further, most companies do better in different phases of the economic cycle. Putting this all together leads to a big divergence in returns for companies over time.

But looking forward, it’s a different story. As I have mentioned, on a forward-looking basis, stocks are priced such that each stock should offer its investors with the same risk-adjusted return as any other stock.

Anytime a trade is placed on a company, the company’s stock gets a fresh start to provide its investors with attractive returns on a go-ahead forward basis.

Accordingly, if a company releases good news, the stock price will jump such that investors after the jump (by the way, good luck with buying before the jump) will be paying for a more expensive stock such that the future expected risk-adjusted return for that stock is the same as any other stock. In this case, the past performance of this stock will be favorable given the jump in price.

Conversely, if a company releases bad news, the stock price will fall such that investors after the fall (again, good luck with selling before the fall) will be paying for a less expensive stock such that the future expected risk-adjusted return for that stock is the same as any other stock. In this case, the past performance of this stock will be unfavorable given the drop in price.

So, even though both stocks will have largely different past performances, their current prices reflect the same expected risk-adjusted returns on a go-forward basis, at least according to theory.

Given this, what is an investor to do?

Back to Basics

Before we continue with this topic, let’s first introduce some terminology. There are hundreds of thousands of stocks that change hands around the world on any given day.

A stock (also known as “shares” and “equity) is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. –Investopedia

Stocks come in two flavors; public and private. Public stock represents shares of a company that trade on a regulated exchange, where market participants are free to buy and sell interests in a company though a public marketplace. Private stock represents interests in a company that are governed through written contracts. For example, a private firm may have an Operating Agreement that lists all the owners of the organization, along with the percentage ownership of each owner.

In the United States, the 500 largest public companies represent about 80% of the country’s public stock market by market capitalization. Thus, by following the performance of these 500 stock prices, we can get a good idea of how well the economy is going. As you may know, the S&P 500® Index is a stock index designed to track this very thing. Further, investors can invest in the S&P 500® Index in order to obtain the “market return”. This market return represents the average return of all 500 companies, weighted by the relative size of each company, where larger companies get a larger weight in the index.

There are many other stock indices in the U.S. and around the world, but perhaps the most famous is the S&P 500® Index. Thus, when investors try to “beat the market”, they are often trying to outperform the S&P 500® Index. In these situations, the S&P 500® Index would be considered the benchmark for these investors; i.e., the investment target that these investors are trying to beat.

Two Competing Alternatives

Now, let’s introduce the two main approaches to investing; passive investing and active investing.

You can think of passive investing as just investing in a stock index, such as the S&P 500®. As described above, with this form of investing you essentially earn the “market return”.

You can think of active investing as any departure from this passive approach. For example, if I were to buy a single stock, or just technology and health care stocks, or some real-estate mixed with classic cars, all this would be considered active investing.

The benefit of passive investing is that it is simple and easy. Also important, it has very low fees associated with it. The benefit of active investing is that it provides investors with the opportunity to outperform the market return.

In Part 2 of this series we’ll begin to lay the groundwork for why I believe passive investing is the way to go in almost all situations.