There is a fairly heated debate on Wall Street regarding active vs. passive investing.
Active Investing is generally when a portfolio manager and a team of researchers analyze the markets, and try to make predictions on which stocks or investments they will buy for their portfolio. They may analyze the earnings, sales and management of a particular company and try to forecast where interest rates or markets might go.
Passive Investing often involves simply mirroring an index such as the S&P 500.
According to Morningstar as of June 30, 2016
Over a five-year period, nearly 92% of large-cap managers underperformed, while 87.9% of mid-cap managers did. A mere 2.42% of small-cap managers outperformed their benchmark index over a five-year period.
Why is this? Why is it that portfolio managers, many of which have advanced degrees from some of the best business schools, don’t seem to be able to consistently beat a simple benchmark index?
I believe the answer has to do with human emotions.
When I went to school all I wanted to do was study business, and thought that a subject like psychology would have no benefit to me in my investing career. I couldn’t have been more wrong. Now dozens of papers and books are being written on the subject of money and our brain. How we interpret data, and how we deal with risk vs. return when the possibility of making or losing “real” money is involved.
One of my favorite stock books of all time is What Works on Wall Street by James P. O’Shaugnessy. Not only does he address active vs. passive investing, he also offers some very interesting insight as to why many active managers don’t out perform their passive benchmark indexes.
“the past records of most traditional managers cannot be predictive of future returns because their behavior is inconsistent.”
James P. O’Shaughnessy, What Works on Wall Street
He goes on to say that the reason why an index like the S&P 500 can perform better than an active manager, is that it sidesteps flawed decision making and automates the investment process by simply just buying “big stocks”.
Why Models Beat Humans (Excerpt from What Works on Wall Street)
Models beat human forecasters because they reliably and consistently apply the same criteria time after time. Models never vary. They are always consistent. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They never take anything personally. They don’t have egos. They’re not out to prove anything. If they were people, they’d be the death of any party.
So is it clear that passive investing wins over active management?
Maybe. While an index like the S&P 500 may outperform many active portfolio managers, the S&P 500 methodology of just simply buying big stocks, may not be the best way to apply a model to choosing investments for a portfolio. Other “factors” may be more reliable for predicting future performance, such as Price to Earnings Ratios, Price to Cash-Flow, Return on Assets and Relative Strength.
Price to Earnings Ratio, One example of a “Factor”
According to the research in What Works on Wall Street, other factors, such as buying stocks with low price to earnings ratios, outperformed the all stocks database*, from January 1, 1964 to December 31st 2009.
- 76% of all one year periods
- 86% of rolling 3 year periods
- 92% of 5 year periods
- 99% of all 10 year periods
*The all stocks database is a subset of the S&P Compustat Active and Research Database of nearly 13,000 securities in North America, which have a market capitalization of a deflated $200 million. Data from 1964 to 2009, which was the latest revision of his research. More recent data may alter these assessments or outcomes.
I believe that discipline with an investment strategy is critical to long term success, thats what indexes like the S&P 500 are able to do. However, there may be a more efficient model that incorporates other factors such as P/E Ratios, which have proven to provide consistently better returns over long periods of time.
Look for investment strategies which incorporate factors that have lead to positive performance over long periods of time.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
No strategy assures success or protects against loss.
Stock investing involves risk including loss of principal.
The prices of small and mid-cap stocks are generally more volatile than large cap stocks.