Thursday, August 09, 2007

Who does better collectively? Active or Passive investors?

Who does better, the active investor or the passive investor? William Sharpe, a Nobel Prize winner, divides the world of investors in “active” and “passive” investors. A passive investor is one who is sensible enough to realize you can’t beat the market. The passive investor who thus knowing his limitation would logically put all his money into a market portfolio of every stock in existence (roughly, an “index fund”).

An active investor is one who suffers from the delusion (if you know what you are doing, it is not a delusion) that he can beat the market. The active investor puts his money into anything except a market portfolio. By Sharpe’s terms, an active investor need not trade “actively.” A retiree who has two shares of Johnson & Johnson in the bottom of his drawer counts as an active investor. He is operating on the assumption that JNJ is a better stock to own than a total market index fund. Active investors include anyone who tries to pick “good” stocks and shun “bad” ones, or who hires someone else to do that by putting money into an actively managed mutual fund or investment partnership.

Who does better was Sharpe’s query: the active investors or the passive ones? Collectively, the world’s investors own 100 percent of all the world’s stocks. In other words, the average return of all the world’s investors – before factoring in management expenses, brokerage fees and taxes – has to be identical to the average return of the stock market as a whole. It can’t be otherwise.

Even more clearly, the average return of just the passive investors is equal to the average stock market return since all passive investors invest in the market index which matches the return of the whole market.

By subtracting the return of the passive investors from the aggregate, this leaves the return of the active investors. Since the passive investors have exactly the same return as the whole, it follows that the active investors, as a group, must also have the same average return as the whole market. This leads to a surprising conclusion. Collectively (not individually), active investors must do no better or worst (before taxes and fees) than the passive investors.

Some active investors do better than others, as we all know. Every active investor hopes to do better than the others. One thing is for sure: Everyone can’t do “better than average.”

Active investing is thus a zero-sum game. The only way for one active investor to do better than average is for another active investor to do worst than average. You can’t wriggle out of this conclusion by imagining that the active investor’s profits come at the expense of those wimpy passive investors who settle for average return. The average return of the passive investors is exactly the same as that of the active investors, for the reason highlighted earlier.

Now factor in expenses. The passive investors have little or no brokerage fees, management fees, or capital gain taxes (they rarely have to sell). The expenses of the active traders vary. For most parts, active investors will be paying a percent or two in fees and more in commissions and taxes. (Hedge fund investors pay much more in fees when the fund does well.) This is something like 2 percent on capital per year and must be deducted from the return.

Two percent is no small cake. In the twentieth century, the average stock market return was something like 5 percent more than the risk-free rate. Yet an active investor has to earn about two percentage points more than average just to keep up with the passive investors.

Do some active investors achieve that? Absolutely. Then do these active investors who have achieved that are also able to sustain what they are doing? Again, a resounding yes. They’re the smart or lucky few – more smart than lucky – who fall at the upper end of the spectrum of returns. The majority of active investors do not achieve that break-even point. Most people who think they can beat the market do worst than the market (worst yet, some deceive themselves by counting the wins but not the losses – ask how many gamblers who always proclaim a win when they strike a lottery). This is an irrefutable conclusion. Sharpe said, and it is not based on fancy economic theorizing. It simply follows from the laws of arithmetic.


fishman said...

Hi Berkshire!

I'm also trying to figure the answer to that question myself.

My solution? I'm involved in both!

Rather I'm currently already invested using passive thinking.(I think) Will go into much more active investing after I've feel I've gained enough knowledge!

musicwhiz said...

Hi Berkshireh,

Your post on active and passive investors does shed some light on the two styles of investing, but how does value investing come into the picture ? On one hand, value investors try to gain a higher than average return from concentrating their portfolio, thus they are active investors. But on the other hand, they also leave their investments for many years without touching them, thus from this aspect they are passive.

Any comments on this ? Would appreciate it thanks !

Berkshire said...

Hi Musicwhiz,

We are all consider active investors as long as we chose to buy stocks, funds, etc. that are not a fund that is tag to an index. Any investor who invests 100% of their funds in an ETF, index is a passive investor because their performance will pertually be the same as the index, no more no less.

As for us, the active investors, the spectrum of performance ranges as high as a mountain to as low as hell. Collectively, the performance will be the same as the passive but individually, it isn't and what determines the difference is the approach.

fishman said...

and hopefully the approach that we chosen will allow us to enjoy success asa high as mountain!

Huat Ah!


Those who seem overly concerned about their stocks on a day to day basis never seem to be very successful investors.