Only Human: Passive Still Beats Active Investing

Yes, it remains true: Indexing is a better strategy than active investing. Passive beats most Humans. Various academic and market studies continue to demonstrate this:

"This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.

That isn’t terribly surprising, said Rosanne Pane, mutual fund strategist at S.& P., because active managers tend to have difficulty beating indexes when market leadership changes. And in the third quarter, many stocks that had paced the market for much of this decade began to fall behind. Small-company stocks were finally beaten by shares of big, blue-chip companies; sectors like energy also started to lose ground.

Still, such transitional periods aren’t the only good times for indexing. S.& P. research shows that while active management fared poorly in the third quarter, it has actually been lagging behind the indexes for a considerable period.

Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S.& P. 500. What’s more, only 16.4 percent of mid-cap funds beat the S.& P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S.& P. 600 index of small-company shares. “The long term does seem to favor the indexes,” Ms. Pane said."

Why do investors bother? Aside from the few who are unaware of the research, my guess is many are attracted by the glory of being part of the 65% that manage to beat the market every so many years: 


Source: Standard & Poor’s; Data thru 9/30/06


For the rest of the time, we all want to be special — in the 20-40% or so who do manage to outperform the indices most years.

 Of course, it’s likely a different 20-40% each year, and is more likely a function of style or asset class (Emerging market, Small Cap, Value, etc.)

Yes, that’s right:  another example of how when your emotional side trumps your rational side, you forfeit gains. Don’t be too hard on yourself, you are only Human.



If You’re Playing ‘Beat the Benchmark,’ Don’t Expect to Win
NYT, October 29, 2006

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What's been said:

Discussions found on the web:
  1. MelvinBeiler commented on Oct 29

    does anyone think that this rally is the handiwork of our treasurer and FR chairman as a payback to the present administration for their appointments? it seems that this rally is being driven in the futures markets (the tail wagging the dog) and the buy programs are being initiated to arbitrate stock prices upward in a vicious cycle. Or is this just my conspiratorial mind in overdrive? The fed buys the paper, and thereby floods the market with liquidity. that liquidity finds its way to the futures market and then to the stock market. Could the treasurer call the boys in NYC to sell distillate futures and buy s&P futures (knowing that the market was poised for a possible short squeeze) ? Or is this just too farfetched?

  2. Pen Island commented on Oct 29

    I think you should go read money shot blog.

  3. crazy commented on Oct 29

    time for RCP to close shop then, and simply post: “BUY ETFs: SPY DIA in dips”

  4. blam commented on Oct 29

    “Despite harvesting the third-largest crop in history, the market has been able to stage a very impressive rally. The corn market has rallied from a pre-harvest low in mid-August of $2.34 to over $3.20 in October.

    The rally has come from several fronts. First, the speculative community is enticed with the long-term bullish demand prospects for corn with increasing ethanol demand and record-large usage forecasted by the USDA. This has encouraged large buying from the funds as well as the overall speculative community. ”

    The futures market is broken. Natural gas, oil, base metals, and now the food supply. Not only are these scum bags imposing a 25 – 100 % market tax on American consumers by manipulating market prices, they are the underlying force creating inflation.

    The United States does not have an effective agency to monitor and control speculative manipulation of prices by the financial institutions. There are plenty of laws on the books but, as typical of the current government, a blind eye has been turned. Self regulating systems are corrupt systems.

  5. Mark commented on Oct 29

    the NYT article brings up a couple questions and thought: What were these funds’ benchmarks? if it wasn’t the S&P 500 (a large cap growth index), who cares.

    Is this a subliminal message to your clients BR? or are you sure you’re the one who can manage to outperform a passive index consistently, (Bogle is one of those too, considering his son runs a hedge fund).

  6. Paul Jones commented on Oct 29

    If you can’t have fun with your money, then what is it for?

  7. Steve C commented on Oct 30

    Actually, the outperformance of index over active mgr. investing may get even wider in the future. The introduction of the Wisdom Tree dividend-based ETFs are likely to outperform their equivalent traditional indices (SP500, Russell 2000, etc) throughout an entire market cycle.
    If you had bought the SP500 at the top of the last cycle (March, 2000) you’re still under water. If you bought (back-dated) the Wisdom Tree large cap ETF you would be up 40%. These new ETFs are going to be the core of my investment portfolio.

  8. CV commented on Oct 30

    For “crazy”–yes close up [kudos to BR though, he basically has no problem arguing agaisnt his pay..] but suggest something like a worldwide diverse allocation:

    SPY, MDY, IWM for domestic, EFA, EEM for foreign equity, AGG for aggregate bond exposure, and a COMMODITY INDEX [Dow is better than Goldman–less oil exposure–capped at 30%], RWR for REITs and a touch of GLD. That plus some cash, sit back, and rebalence after 366 days to avoid short term cap gains [assuming that tax legislation survives]

    That’s it folks

    As for “Mr Wisdom Tree”.

    Beware the “back dated” results. I suggest you chant the mantra “lies, damn lies, and statistics” every day. The latest before this was the ‘proof’ that neutral market cap weight s and p 500 funds did better than traditional s and p 500 market cap weighted funds. My research proved that this was in fact because the market cap neutral funds in fact where skewed towards more midcap-ish companies [think about it for a second]. If you recall, midcaps handily have out performed large caps.

    BR– if you would like my white paper on that proof to post in any way you see fit, happy to send it on–i don’t run other’s money and have no conflicts of interest, was purely an academic exercise.

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