Today’s vlog is is the third in my series about investor education. So, in the first part, I talked about mutual funds and, more specifically, I talked about why many mutual funds may fail to beat their underlying benchmark indexes. Then, in part 2, I talked about the S&P 500 and what may probably be one of most popular of these benchmark indexes that people sometimes invest in and I talked about some inherent risks that may be associated with the S&P 500 that people may not realize.

In today’s vlog, I want to continue this conversation and I wanted to talk about what may be one of Wall Street’s most heated debates right now, and that’s active versus passive investing.

First of all, let’s begin by talking about what is active investing and what is passing investing. Active investing can probably best be represented by, if you think of a portfolio manager or a team of portfolio managers and their job is to try to make predictions about where the market may be going or what the economy may be doing. it could be what interest rates are doing, if they’re going to go up or down, and how that may impact some of the investments they may be buying for the portfolio. They may also do individual research on stocks. They sit around boardrooms, they may have discussions about whether they should buy Netflix stock or Amazon stock, and whose product is going to be better, and what new things may be coming down the pipe for either of those companies. And again, their job is to try to put this research together in such a way to hopefully build some performance for their clients, and one of their goals is usually to outperform their underlying benchmark, or the passive investments. And hopefully they’re able to do that. But, as we learned in the first video, according to a lot of research from Morningstar and S&P that unfortunately these active managers fail, in many cases, to beat their passive investors.

So, what does a passive investment do? Well we talked about this yesterday, if we look at the S&P 500, their job basically is to put money into 500 of the largest stocks in the United States. And again, we talked about the market weighting of that, so more of the money goes into those bigger name stocks, so it’s a little bit top-heavy, but those passive investments do that with extreme discipline. If you think of a passive investment approach, they don’t care who the president of the United States is, whether it’s a democrat or republican, they don’t care if we’re at war, or they don’t care what interest rates may do, or who the chairman of the Federal Reserve is, they just consistently apply that discipline through all market conditions. And I think it’s because of that discipline that they’re oftentimes able to outperform these active managers that are oftentimes trying to outguess the market, they’re trying to second guess everything.

One of my favorite books about investing is a book by James O’Shaughnessy called What Works on Wall Street, and in the beginning part of his book, he does a lot of exploration into human behavior, and some psychology as to why people may do some of the things they do when it comes to investing. He cites a great psychological study that begins by pretending that there’s 100 people in a room, and we know that 70 of those people are engineers, and we know 30 of those people are attorneys. And if I said to you I’m going to give you ten dollars for every person that you can guess right. You get to guess if they’re an attorney or if they’re an engineer. Well not knowing anything about those individuals, the smart thing to do would be to guess that they’re all engineers, you know, and then we know we’re going to get 70 percent of them right, because 70 percent of them are engineers. Or we’re going to make 700 dollars off of that. And that’s what most people do, or at least what most people should do, not given any information about those individuals. However, in that same example, if we gave you a file on each one of those 100 people and it had information about their family, whether they were married or had kids, what kind of hobbies they liked, did they like to play golf, or if they liked to build things, or whatever it may be, and then you could re-guess if they’re an engineer or an attorney. And most of the time, given this new information, people will try to out-guess what we consider to be the base rate, knowing that 70 percent of those individuals are attorneys, and in almost every single instance, our individual thoughts about that are wrong and we don’t even do as well as the base rate. In other words, we don’t even guess 70 of them correctly. And what James O’Shaughnessy talks about is that’s a lot about what’s happening here with the market. Given all of this information, we all have tons of information, it’s very difficult to interpret that information, and to make sense of it, and to really out guess what we know to be the base facts.

So if we think about this active versus passive again, I think one of the main reasons that passive investing works is because it has a very simple discipline and it sticks with that discipline through all market conditions, no matter what may be going on. And its discipline, again, is very simple. It’s buy big stocks. If we’re talking about the S&P 500. And so the first question is does that makes sense. Is that the best criteria that we should be using to select these stocks for our portfolio? And what James O’Shaughnessy talks about in What Works on Wall Street is, buying big stocks is not an indicator of future performance, in fact if we look at a lot of the data, it actually suggests that small or medium sized companies actually, historically, have done much better than large company stocks. But what he goes on to talk about is there are other factors that may lead to us having a better ability to pick good names. And some of those factors might be price to earnings ratio, and that might be one of the best ones that he cites in his book. And if we just look at price to earnings, and I know we talked about that in the last video, but it’s a good measurement of how expensive a stock is relative to those earnings. The higher the PE ratio, the more expensive that stock is relative to those earnings, and the lower the PE the cheaper that stock is. And what he outlines in his data, if we look at the stocks that have the lowest PE ratio, those stocks are able to outperform the overall stock market averages. And the stocks that have the highest PE ratio, those stocks tend to underperform.

So one simple thing, buy low PE stocks is going to potentially lead to above average results. But again, the reason why this factor base works is that it’s, first of all, we think it’s a better factor than simply buying big stocks, but it works because we’re able to execute that strategy with the same kind of discipline that these passive investors use. And so that’s one of our philosophies that we have here with the portfolios that we manage, and a lot of our portfolios are using some of these factors. Other things might be things like price to sales, as an example. We might look at momentum as another good indicator. So how a stock has performed over the last six or 12 months is another good indicator of future performance, and we know that because in What Works on Wall Street, James O’Shaughnessy did that research and went through 50, 75 years, in some cases almost 100 years worth of data that shows that those stocks consistently outperform. Now again, they’re not going to do it in every single market environment. Is it possible that we go through a period where low PE stocks underperform? Absolutely. Is it possible that high PE stocks outperform? In some cases, yes. But over time is what we’re really looking at, is what is that long-term trend. So anyway, I hope this makes sense, and when you’re thinking about active versus passive, also realize too that there may be an opportunity that kinda lives in the middle here where we’re using factor based approaches to putting our portfolios together. But again, the reason that this works we believe is because we’re able to use those factors with the same kind of discipline as a passive approach.