Wednesday, December 15, 2010

Sometimes It Pays To Be Passive

If you ask most people whether it is better to be passive or active, most people would answer active, which is not much of a surprise.  When you think of being active, you think of taking the initiative, of exerting influence over ones environment, of attempting to bring about change.  On the other hand when you think of being passive, you think of letting events control you, of not participating, of submitting to the will of others.  A passive person is timid while an active person takes charge.  When it comes to investing, the words active and passive come into play as well.  You can be an active investor, or you can be a passive investor. 

Which is better?  Most people would immediately say that active investing is better.  However, is that really true?

First, let's define what it means to be an active investor versus being a passive investor.  An active investor attempts to seek out winning investment opportunities.  They try to find those stocks which are going to go up in price, and they try to avoid those stocks which are going to go down.  They attempt to time the stock market by buying when its prospects look good and sell when they look bad.  Generally speaking, they actively choose what stocks to buy and when to buy them.

A passive investor doesn't try to figure out which stocks to buy.  Rather than picking and choosing which stocks to buy, a passive investor buys every stock through an index mutual fund.  Rather than trying to time the market to figure out when it will go up and down, a passive investor invests the same amount every month.  Generally speaking, a passive investor doesn't concern himself or herself with the movements of the market or individual stocks.

Which is a better strategy?

Obviously, if you could figure out which stocks are going to go up and which are going to go down, it is better to buy the gainers and sell the losers.  The key word is "if".  Can somebody figure out in advance which stocks are going to be winners?

If you have been a loyal reader of this site, you probably can guess what my opinion on the matter is.  I am of the opinion that there is no way to reliably and repeatedly predict the direction of individual stocks or the stock market as a whole.  You may get lucky from time to time in the same way that a blind squirrel finds a nut.  However, don't confuse luck for skill.

Professor Burt Malkiel laid out an excellent case for the random nature of financial markets in his book A Random Walk Down Wall Street.  His premise is that any information that would influence the price of any individual stock is already incorporated in the price of the stock.  In academic circles, this is known as the efficient market hypothesis or EMH.  Here is an example of how the this works:

Let's say that the Food and Drug Administration announces that they determined that a certain drug cures cancer.  Obviously, the company that developed this drug is going to make billions and billions of dollars selling this miracle cure.  As an investor you would think that it would make sense to buy the stock of this company in anticipation of the coming windfall.  However, within seconds of the announcement, the people who hold the stock will demand a much higher price to part with their shares of stock.  Before you can even pick up the phone to call your broker, that information will have caused the stock price to rise, and you will have missed out on any financial benefit from knowing that information.

This is true of any type of information about a stock.  By the time it becomes public knowledge, it is too late to benefit from that information because that information is already incorporated into the price of the stock.  It would appear, then, that the only way to figure out which stocks are going to go up is to have some information about the stock that nobody knows about.  By the time you read about it in the Wall Street Journal or see it on CNBC it is way too late.

Now if you are egotistical, you may think that you are special.  You may think that you are smarter than the average stock trader because you have noticed something that nobody else has seen.  You are wrong.  There are always events that affect the price of stocks that nobody can predict unless they are psychic.  There is no way to predict natural disasters.  Who could have predicted the wildfires in Russia which caused a shortage of wheat?  Who could have predicted that a well in Gulf of Mexico would explode and lead to one of the biggest environment disasters in U.S. history?  Who could have predicted that there would be a terrorist attack that would cause a total shutdown of airline travel and then lead to two wars?  All of these inherently unpredictable events impacted various stocks on the stock market. 

Many people use what is known as charting or technical analysis.  This involves looking at the movement of stocks to see if there are patterns.  There is a whole litany of terms for various patterns, and these patterns supposedly indicate whether it is time to buy or sell a stock.  The mere fact that these patterns are well known means that they cannot be exploited.  Let's say that there is a pattern that a stock always rises on a Wednesday.  Once that pattern becomes common knowledge, people will start buying on Tuesday in anticipation, and the stock price will go up on Tuesday instead of Wednesday.  The mere identification of the pattern eliminates the pattern in a "quantum physics"-y kind of way.

The biggest counter argument to the efficient market hypothesis and passive investing is Warren Buffett.  Warren is one of the richest men in America, and he made his money by investing in stocks of companies that he thought would increase in value.  Certainly his track record speaks for itself.  The stock of his company, Berkshire Hathaway, has gone up 76% over the past decade.  Meanwhile, the S&P 500, which is price of 500 large U.S. corporations, has gone down over the past decade.  It appears as if Mr. Buffett has trounced the overall stock market through shrewed investment decisions.  If Mr. Buffett can do it, then anybody should be able to do it, right?

Well... not really.

First of all, Mr. Buffett isn't your ordinary investor.  When most people buy a stock, they exert no influence over the management of the company they buy.  Sure, they get to vote for the board of directories and an ocassion proxy question.  However, those votes don't really count for much.  When Warren Buffett buys a stock, he doesn't buy 10 shares or 100 shares.  He buys thousands or even millions of shares.  When he wants to influence how a company is managed, he can call up the CEO, and his calls get answered and his advice gets listened to.  He is not only an investor, but he is an owner in the truest sense of the word.  If you or I think that a company is heading in the wrong direction, we have no way to change the company's course.  We can only sell our stock and move on.

Second of all, Mr. Buffett has access to deals that the average investor doesn't.  At the height of the financial crisis, Mr. Buffett was able to buy $5 billion of "preferred stock" in Goldman Sachs.  This preferred stock was a sweet deal for him.  It pays out a 10% dividend every year, meaning that he gets $500 million every year from Goldman Sachs in return for his investment.  The average investor would have loved to get in on this deal, but it was offered to Mr. Buffett and only him.  It is easy to make a killing on stocks when you are a preferred customer.

Finally, investing is Mr. Buffett's life.  He spends more time thinking about stocks then most people think about everything else combined.  In addition, he employs a team of experts to assist him in his work.  If there is any insights to be gained into how a stock if going to perform, Mr. Buffett and his team will know about it, and they will know about it before you or me.  That is an advantage that he and all of the other professional investors have over us average folks.

If you don't believe me that passive investing is the way to go for the average amateur investor, maybe you will take the word of the master himself.  Warren Buffett has stated repeatedly that most people are better off investing in index funds rather than in individual stocks.  He has even gone so far as to bet that Vanguard's passively managed S&P 500 stock index fund will outperform five hedge funds (proceeds going to charity).

The bottom line here is that it is difficult (if not impossible) for the average person to consistently predict the stock market.  Rather than trying to predict it and see your predictions go wrong, you are better off just buying a low cost index fund that contains every stock and calling it a day.  It just goes to show that sometimes the passive approach is the best approach.

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