In the investment world, there is an ongoing dispute over passive investing. Basically, the evidence shows that passive investing (through index investing) out-performs active investing. This is one of Burton G. Malkiel’s main arguments in “A Random Walk Down Wallstreet.” He famously claims that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts” (pg. 26). As Professor Kimball has also reiterated numerous times, getting rich in the stock market by carefully selecting specific stock, is simply a matter of luck. This is the basis for Malkiel’s claim that index investing is the best way to go.
First, it is important to understand exactly what index investing is. As defined by Investopedia, an index fund is “a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.” Index funds are known for having low costs and for being handled passively, meaning there is no active management like in active stock portfolios. Here is where financial advisors come in. The argument behind whether indexing is a better strategy is mostly alive because advisors benefit from charging high fees when managing active portfolios. They do not benefit from suggesting to clients to invest by indexing, because they gain lower fees from doing so.
And as Malkiel (as well as Professor Kimball) likes to point out, financial advisors who claim to be able to make you enormously rich in the stock market, following their pretty formulas, are full of it. Of course, there is a basic science to it: buy low, sell high. But besides this, it is pretty much up in the air. An article in Forbes does a nice job of explaining the benefits of indexing, and the lies told by advisors about it: “exhaustive academic studies covering the active versus passive debate going back many decades…ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance.” It is interesting that the author acknowledged that skill may be a factor, but then states it is impossible to differentiate between skill and luck. Indeed some people are probably very skilled in managing active investments, but the likelihood of finding an advisor like this is so low that it is not worth the trouble. Either way, if you were to find such an advisor (like was pointed out) it is impossible to know the difference between luck and skill. Unless, of course, you are willing to trust in their luck.
The five lies outlined as being frequently used by advisors in order to sway investors away from indexing are the following:
1. Active US stock funds beat the market over the past decade.
2. Index funds will always achieve below average returns.
3. Indexing doesn’t work in inefficient markets such as small cap or international
4. Active managers perform better in bear markets
5. Warren Buffett has beaten the market and this proves indexing doesn’t work
I encourage you to read the reasoning behind recognizing these claims as lies. For the sake of longevity, I won’t get into them. But it isn’t so hard to understand the concept. And it makes sense that active investing is encouraged by those who benefit from high fees (advisors). It seems that the only reason for this argument to even be an argument, and not a fact, is that there is a clear conflict of interest with those involved. Finally, I’d like to point out that I have nothing against advisors, and I plan to go into the field myself. But I certainly think there are better ways to perform this service, that doesn’t involve deceiving clients in matters like this one.