Investors can either take an active or passive approach when investing
(Originally posted in 2020)
When investing, there are two investment strategies that can be employed. Investors can either take an active approach, which attempts to beat the market, or a passive one that captures the returns offered by the market. As data driven wealth advisors, we respect the mountains of evidence that highlight how outperforming the market is very unlikely and costly to attempt. Instead we focus on efficiently capturing market returns.
A capture strategy generates returns that match those available from the market. To achieve this, investor portfolios mirror the holdings of the greater market. Alternatively, a beat strategy aims to outperform the market by concentrating its holdings. These concentrations can be based on a country, industry, or company. Although this strategy offers the potential for increased returns, it also exposes investors to portfolios that underperform.
Historically, the stock market has generated very strong returns. By combining good behaviours with these strong market returns, investors have been able to live the lives they want. However, we are human and believe that more is always better. If we can beat the market and get better returns, then we can have better vacations and retire earlier. But, is the potential increase in return worth the risk?
Is It Worth The Risk?
Instead of asking if you should take the risk, ask yourself if you believe that you can accurately pick companies, industries, or countries that will outperform the market. If not, ask yourself if you believe that you can pay an individual, team, or computer to identify these stocks for you.
Before we quickly jump to a yes, we need take a minute and understand what we are up against. Markets are prediction machines that communicate information to the public through stock prices. Think of the stock market as an auction where buyers and sellers come together to trade products. To buy a Picasso painting you would need to go to a private art auction.
At that auction, both the seller and the buyers would be informed about the painting. For example, they would know how much past paintings have sold for, how many have previously sold, and the total number remaining in circulation. Before anyone raises a paddle to make a bid, this collective wisdom informs everyone as to what the painting might be worth. The stock market acts in the same way, but instead of paintings, buyers and sellers trade stocks.
The Efficient Market Hypothesis
To understand the effects of collective wisdom on markets, economists have developed the efficient market hypothesis. This theory tests whether a person, team, or computer can enter a market and consistently outsmart everyone else in the room. Thus, producing better returns as a product of skill and not just luck. Like everyone who claims to have bought Netflix instead of Blockbuster, ten years ago.
The efficient market hypothesis does not outline that it is impossible to beat the market. Instead, it states that no person “should” be able to beat the collective wisdom of the market. With all of the same information available to everyone, picking winners is unlikely. The stock market is effectively a zero sum game where there are winners and losers. The efficient market hypothesis also helps to prove that the winners are a product of luck and not skill.
The Results of Using Active Investment Strategies
As an independent evidence based firm, testing professional money managers using this theory was important. We found that in 2019, only 8 per cent of Canadian equity funds were able to outperform the market. Meaning that the vast majority of investors who subscribed to active investment strategies lost so that a small minority could win. What are the odds that those same winners will be able to do it again?
History indicates that only a handful, if any, will be able to consistently outperform the market. Further outlining that beating the market is a result of luck and not skill. With such a small chance of picking the right stocks and getting it right year-over-year, the data suggest that it is not worth the risk. Instead, we are better off using on passive investment strategies that focus on good behaviours and effectively capturing what the market has to offer.