Investors and advisors perennially debate the merits of active investing vs. passive investing, but abundant evidence shows passive investing typically produces superior long-term returns.
The evidence is clear from reams of objective research performed by academic finance and economics experts who have no conflict of interest — their incomes won't change no matter what they find. Overall, their examinations of returns since passive vehicles became widely available in 1976 show passive management's average superiority.
Passive management came into its own during the long bull market that started in late 2009, after the market had collapsed amid the financial crisis in 2007–2008. Money had been flowing from active to passive vehicles in the preceding years, and investors — disillusioned by their losses in the crisis and the high fees they had paid — started turning to passive vehicles even more. That trend has continued to this day.
Active management presumes that by picking the right individual securities or engaging in market timing, investors can beat the market. But in the face of contrary evidence, stock-picking really makes no sense, because it assumes one can consistently identify securities the market has mispriced. This is really nothing more than speculation.
Some active managers may hold stocks for long periods, but there's no way they can consistently know which stocks will do well and which won't.
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Various long-term studies have shown that, net of fees, actively managed mutual funds tend to underperform the S&P 500. This mounting evidence has prompted various huge institutional investors, such as the California Public Employees' Retirement System (CalPERS) to move much of their assets into passive vehicles.
One problem some investors may have with evidence-based investing is passive vehicles are boring; they quietly provide investors with predictable, marketlike returns. By contrast, active investing is anything but boring. Picking stocks, or paying managers to do so, gives investors a thrill. For many, gambling is thrilling, and in many ways stock-picking is akin to gambling.
In his book "Your Money and Your Brain: How the New Science of Neuroeconomics Can Make You Rich," Jason Zweig, the renowned financial writer, discusses the brain chemistry of gambling. When people are seeking big winnings from long shots, Zweig writes, they get a rush of dopamine, a neurotransmitter associated with excitement and, potentially, with addiction. Such longshots would include picking stocks. Zweig's apt examination of the neurochemistry of gambling and how it applies directly to stock-picking is an eye-opener.
Yet many people apparently don't want this kind of excitement. Morningstar data from 2017 show net inflows into passive funds of about $692 billion and net outflows from active funds of $7 billion. However, at year-end the total assets of actively managed funds were $11.4 trillion, compared with $6.7 trillion for passive funds.
The conclusion from this is many investors have remained unaware of passive management's superiority. A big reason for this is the powerful marketing machine for active management that extols the virtues of active management investment companies. Ironically, this expensive marketing and advertising is one thing that drives up fees paid by active investors, significantly reducing returns.
Investors who heed objective evidence and practice evidenced-based investing, realize the pitfalls of investing based on emotions, unlike those who seek the dopamine rush of a longshot. Many of these gamblers will likely regret they sought these thrills 10 or 20 years down the road. Those who engage in evidence-based investing are less likely to have such regrets.
(Editor's Note: This column originally appeared on Investopedia.com.)
— By Tim Decker, president and CEO of ISI Financial Group
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