Passive vs. Active
Passive Management of Portfolios is Superior to Active Management
The goal of active portfolio managers on the whole is to beat the market. In order to accomplish this feat they must do so through market timing and security selection. However, the result is that 85% of the time active managers fail to meet or beat their respective targets and only succeed in generating higher fees and trading costs, and increased taxes due to turnover. In other words, 85% of the time active management leads to underperformance and higher costs!
You may ask, why not choose the 15% who actually succeed in beating the market? The answer is simple – beating the market is a random event, thus a different set of managers do it each year! Remember, markets are efficient and mispricings are random; therefore, how can a manager take advantage of random events? Of course, everyone wants to believe there is someone out there who can predict market movements and consequently “figure the markets out,” and there will always be sharp managers that make that claim, but the reality is no such person exists. Even harder than managing a portfolio that always beats the market is identifying that manager in advance and identifying when that manager will start losing money in advance.
On the other hand passive managers accept asset class returns. If the asset classes or the benchmarks are beating the active managers 85% of the time, why not buy the asset classes or benchmarks? This strategy sacrifices trading costs and turnover in favor of tracking. Instead of a concentrated and focused portfolio typically associated with active managers, passive asset classes and indexes have a much broader range of stocks in their portfolios resulting in less volatility. The result is a better-diversified, longer-term, and cost-saving strategy that is far superior in the long run.
Remember this: 94% of portfolio returns can be explained by asset class selection! Market timing and stock selection make up the other 6%. In other words, 15% of active managers are successful in “beating the market” in any given time period, and for that work, only 6% of the changes in your portfolio can be explained by the actions of those active managers. The rational and prudent method of investing involves working with passive managers and avoiding the guesswork of selecting active managers.