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| > Investing > Fiduciary Focus |
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| Fiduciary Focus: Active vs. Passive Investing (Part 2) |
| by
W. Scott Simon
| 03-30-05 |
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This month's column continues the series I began last month that explores active investing and passive investing within the context of modern prudent fiduciary investing.
There is widespread belief among investors, repeated endlessly by the investment media, that opportunities to beat the market are greater in "inefficient" markets. Skillful investors are said to have a better chance of uncovering investment "gems" by picking "inefficiently" priced stocks such as small-company stocks and emerging-markets stocks--stocks that most investors "ignore."
The media, though, doesn't tell investors about a much more important story: the critical difference between the (very consequential) fact that active investing in all financial markets is a zero sum game and the (less consequential) belief that a particular financial market is efficient or inefficient. That difference helps explain why passive investment strategies are ordinarily the most prudent for fiduciaries to use not only in efficient financial markets but, surprisingly, in inefficient markets as well.
That Active Investing in All Financial Markets Is a Zero Sum Game Is a "Fact"
A powerful argument in favor of passive investing (particularly germane to fiduciary investors) rests on the simple arithmetic of a zero sum game. It is a fundamental, yet little understood, mathematical fact (not a belief) that active investing in all financial markets such as the stock market in the United States or the bond market in South Africa is a zero sum game.
Game Theory (a branch of mathematics first developed in the 1920s) posits that there are three kinds of games: a positive sum game where, on average, people win, a negative sum game where, on average, people lose, and a zero sum game where some win and some lose but, on average, people break even. Some of the "games" studied by Game Theory are nuclear war, raising children, and investing.
Nuclear war is a negative sum game where all lose. Government think tanks used Game Theory for many years to simulate what could happen in a nuclear exchange between the U.S. and the USSR. (Fortunately, they realized that it was a very negative sum game called Mutual Assured Destruction and decided not to play.) Raising children is a positive sum game in which both parents and children win. It may not seem that way, though, when trying to get the kids to go to bed at a reasonable hour. Active investing--defined as holding any given subset of stocks other than what comprise the market portfolio--is a zero sum game where some investors will win and some will lose relative to the return of the market or a market segment.
Those that participate in a financial market consist of three groups of investors: passive investors who earn the market return, active investors who outperform it, and active investors who underperform it. To avoid confusion, note that the zero sum is not 0 but the actual return of a financial market or market segment. For example, in 1995 the return--as well as the zero sum--of the S&P 500 index was 37.58%.
The losing active investors who underperform a financial market may be characterized as "sacrificial lambs" for the winning active investors who outperform it. For example, suppose that there are four investors in a particular financial market--three active investors and one passive investor. Further suppose that the market return was 30% last year and that one of the active investors outperformed that return--by 20 percentage points--thereby earning a return of 50%.
The other two active investors must have collectively underperformed the market return by 20 percentage points, thereby earning a return of 10%. The reason why is simple arithmetic: the amount of gain by which any investor (or investors) exceeds the return (i.e., the zero sum) of a financial market must be balanced by the same amount of loss that another investor (or investors) incurs when he or she underperforms that return. The fourth player (the passive investor) earned the market return (i.e., the zero sum) of 30%. A passive investor is never a sacrificial lamb that loses to winning active investors.
Note that the returns in this example are before costs. After costs are taken into account, the one winning active investor actually earned less than 50% and the two losing active investors earned less than 10%. The "dead weight" of costs reduces the outperformance of the winner, just as it increases the underperformance of the losers. These facts dictate two mathematically certain outcomes.
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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