Myth #1: We can identify stocks that will go up in the future

Stock Picking

You can choose from two competing investment philosophies, Active or Passive. Active investing is based on predicting the future movement of stocks and picking those stocks, hence the term stock picking. Or, you can reject the idea that anyone can predict the future and simply accept the returns of the stock market by having small stakes in thousands of stocks…passively taking what the market gives freely and naturally.

The following study of Active versus Passive investment returns clearly shows the superiority of passive investing, and the false promise of stock picking.

The debate over market efficiency may never be settled. But no one can argue the historical returns evidence, which shows that active management does not pay for itself, in aggregate.

The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance. Yet active managers test the hypothesis every day through their efforts to pick stocks and time markets. The evidence shows that their efforts are not worth the high cost borne by investors. This slide displays the percentage of actively managed public equity funds that failed to outperform their respective market benchmarks for each major fund category for the five-year period ending December 2010. Most of the fund categories failed to beat their respective benchmark as a group. This is consistent with research, which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses.

The lone exception is the international small fund manager category during the period. As indicated in the graph, 24% of this group failed to beat the respective benchmark, which is the S&P Developed ex-US Small Cap index. More detailed analysis reveals that many managers in the international small category had significant holdings in emerging market stocks, which is a different asset class that had stronger performance during the period. The large percentage of outperformance among international small managers may result from a large portion of them holding a different asset class and being compared to the wrong benchmark.

If the manager group’s average return is benchmarked to an international small cap index that includes emerging markets, the rate of underperformance rises to over 60%, which is in line with the other equity fund categories. (Benchmark is the MSCI All Country World ex USA Small Cap Index.)

Research by Eugene Fama and other financial academics has offered evidence that the bond markets are efficient and that interest rates and bond prices do not move predictably. This appears to be the case with all types of issues, from short-term government instruments to long-term corporate bonds. This slide illustrates the formidable challenge that active bond managers face. The graph shows the percentage of active fixed income funds in each category that failed to beat their respective market benchmark for the five-year period ending December 2010. All categories had at least a 56% failure rate, with failure defined as underperforming their benchmark. This is consistent with financial theory and research, which propose that active managers cannot outperform the market as a group, particularly after accounting for management fees, trading costs, and other expenses.

WHICH CHOICE OF INVESTMENT MANAGEMENT STRATEGIES DO YOU WANT FOR YOUR FINANCIAL FUTURE, ACTIVE OR PASSIVE?

Myth #2: We can predict the timing and duration of the market’s ups and downs

Myth #3: A manager’s track record is a strong indication of future performance