Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards

Retirement Planning > Retirement Investing

The Real Point of Active Investing

Your article was successfully shared with the contacts you provided.

Among the most brilliant and successful political tactics I’ve ever witnessed was the Republicans’ decision, decades ago, to use the words “tax-and-spend liberal” to repetitively and pejoratively label Democrats.

The phrase was so resonant with individual voters that it led to a Republican resurgence that continues to this day. But it also prevented what could have been an important national conversation over the ultimate role and size of government. Labels are powerful because of their simplicity. But used too often or too long, their simplistic message can result in one-dimensional thinking—with predictably terrible results.

“The goal of active investing is to outperform the market.”

I cannot count how often I have seen variations on the theme of this apparently sensible observation. There certainly doesn’t appear to be much, if any, argument with its conclusion. It is so ingrained in our thinking and so seemingly obvious that I’ve never come across anyone who was willing to claim that the goal of active investing has nothing to do with outperforming the market.

So I’ll do it: “The goal of active investing has nothing to do with outperforming the market.” Admittedly, it looks like I’m just trying to be provocative with a foolishly illogical statement. But one of the most valuable lessons I ever learned was the importance of knowing the difference between something that appears foolish and something that actually is foolish. For investors that distinction can mean everything.

Before we can evaluate the goal of active investing, we first need to step back a bit and understand the activity we know simply as investing. The purpose of investing is obviously different for each investor—but the fundamental reason that leads us to take money out of the bank and sink it into an enterprise is that we believe that our opportunity for profit is worth the risk. Whether the investment is a four-unit apartment, our own business, a few shares of Berkshire Hathaway or an index fund—the basic calculus is always the same.

In terms of stocks and bonds, the common denominator among successful strategies of all varieties (both legal and illegal) is that they are able to identify something that can be exploited profitably. For example: Inside information exploits non-public secrets; a Ponzi scheme exploits investor greed; value investing exploits investor impatience and short-termism; highspeed trading exploits inefficiencies in the market mechanism; micro-cap investing exploits opportunities created by a lack of Wall Street research; and indexing exploits the efficient market hypothesis. There is no end to it. The number of potential investment options is limited only by the creativity and insight of market participants.

Curved Reality

The hard truth, the inviolable law of human affairs, is that in whatever activities we engage, whether in school, sports, arts, community, government, work or investing—the bell curve applies. A few of us will be truly outstanding, and a few of us will be completely inept. But most of us will be end up being somewhere above or somewhere below average. There’s not much we can do about this. I will never swim like Michael Phelps or write anything as compellingly interesting as Michael Lewis. But my body is energized by swimming, and my thoughts are clarified by writing. The pleasure and satisfaction I get from my competence in these activities has nothing to do with where I am on the bell curve, even if it could be known. The activity is its own reward.

While investing falls squarely within the crosshairs of human affairs, maintaining a good distance from the far left side of the bell curve is a legitimate and important goal. As with every other human activity, the only sensible and rational way to respond to the investment challenge is to draw on all of our resources and do our best. In a world where almost everything is out of our control, how we respond to things (i.e. our choices) is the one area where we can exercise control and thereby make a difference in the outcome.

This is the nature of active investing. Its simple goals are to make good choices, learn from our mistakes (and from the mistakes of other investors) and thereby become a little better at it. Over time these small incremental improvements can make an enormous difference in keeping us away from that part of the bell curve we are trying our utmost to avoid. Indexing’s perfect record of keeping investors toward the right side of the bell curve has given its supporters pole position in the race to define the nature of the investment challenge. “Active or passive” is increasingly the first question investors ask themselves when considering the universe of their choices.

If you hold (as I do) that investing is just one of many human activities—then just like those other activities, we have no choice other than to be active participants. The decisions of where you will invest your money, and within that choice what kind of strategy you will employ, also require active decisionmaking. Only in the world of securities is passive investing even possible, and only within the last 40 years has a particular form of passive investing (indexing) become the most popular and successful expression of that concept. “Active or passive” is a legitimate investment choice, and within the proper context the choice can be evaluated dispassionately. Artificially changing that context however can lead to problems.

Rick Ferri is a smart investor, a clear thinker and a successful cheerleader for indexing. He wrote a very interesting piece on smart beta in the March edition of Journal of Financial Planning. Ferri suggests that there isn’t anything particularly “smart” about smart beta other than that it is just another strategy that has been recently successful; and like other strategies before it, its success may sow the seeds of its ultimate demise. He writes: “The risk of asset bloat has a special name in this space. It’s called ‘factor crowding,’ when too many dollars chase a limited supply of opportunities.” To bolster his argument, Ferri quotes John Bogle’s famous observation: “Nothing fails like success.”

It occurs to me that in the history of the securities markets there has never been a more popular or more successful strategy than indexing. Studies I’ve seen recently estimate that between 35-40% of U.S. equities are currently indexed, and the trend appears to be accelerating. The dollar amount invested in smart beta strategies wouldn’t even qualify as a rounding error in comparison to the dollars that are following indexing strategies. I don’t recall hearing any warnings from either Bogle or Ferri about indexing becoming too successful or its factor becoming too crowded.

Buffett’s Rules

Warren Buffett and Charlie Munger are probably the most famous and successful investors on the planet. Their pithy observations appear to be so simple as to be self-evident. But like all wisdom, the paradox lies in the fact that simple is rarely easy. Buffett’s two basic rules of investing—rule No. 1: don’t lose money; rule No. 2: don’t forget rule number one—sound almost ridiculous until you try to actualize them. And Munger’s brilliant observation that his and Buffett’s success had more to do with being consistently not stupid than being intelligent, is the absolute essence of what being an “active” investor is all about.

Indexing may be a form of passive investing, but it should always represent an active choice—built on our individual and collective experience and judgment. Following Buffett and Munger’s advice may lead you to index or it may not. It may lead you to above-average performance or it may not. But it will definitely keep you firmly in the real world and therefore out of trouble—and that is the goal of active investing.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.