Passive investing beats active. That’s the inference to draw from the fact that Warren Buffett won his bet against hedge fund Protégé Partners. Back in 2007 he bet that an S&P 500 tracker fund would outperform its selection of hedge funds up to the end of 2017. It did so so handsomely that Protégé Partners conceded defeat months ago.
This poses the question. If passive investing is so good why don’t more people do it?
There are legitimate reasons. At least two strategies – momentum and defensive investing – do beat passive investing on average over the long run. And when smaller stocks do well, most shares outperform market indices weighted by shares’ market capitalisation, with the result that anyone picking stocks at random with average luck will beat the market.
These reasons, though, don’t explain the ubiquity of stockpicking. Few stockpickers confine themselves to betting on defensives and momentum. And hardly any switch between active and passive investing according to views on whether small-caps will beat larger ones or vice versa.
Santa Clara University’s Meir Statman says there’s another reason for the popularity of stockpicking. In his recent book Finance for Normal People, he says it is based on a handful of mistakes.
One, he says, is that people confuse two different conceptions of the efficient markets hypothesis. One of these is the idea that prices always equal value – that they are always right. The other is that markets are hard to beat.
It’s easy to reject the “price equals value” claim; you’ll all have your favourite example of egregious mispricing: the tech bubble and burst; the overpricing of mortgage lenders in 2005-06; the underpricing of housebuilders in 2009-10 and so on to Bitcoin.
But it doesn’t follow from this that markets are easy to beat. Even if shares are mispriced you might be unable to exploit this fact. An irrationally underpriced share can always become even more underpriced. And good strategies in theory can fail in practice because of difficulties in implementing them, such as high dealing costs or margin calls on short sales. “Markets may be crazy,” says Professor Statman, “but this doesn’t make you a psychiatrist.”
What’s more, there are two common errors of judgement that bias some of us towards active management. One is the availability heuristic. The handful of shares that have risen a lot get lots of attention. So, too, do the few fund managers who have beaten the market over significant periods. The many shares that have pootled along with moderate returns don’t get so much attention, however, and the countless investors who lose money keep quiet. The upshot is that the possibilities of beating the market are more available to our minds than are the possibilities of underperforming it. This causes us to overestimate our chances of outperforming.
A second bias is overconfidence. We all like to think we’re cleverer than average and so can beat the market. This means that empirical evidence actually backfires. “Most investors who attempt to beat the market are beaten by it,” writes Professor Statman. Overconfident investors, however, read this as evidence that other investors are stupid and so they can do well by exploiting their irrationality.
Many of you will reply here that you know all this and regard stockpicking as an enjoyable hobby, pitting your wits against the market’s. This, however, can lead you into another expensive mistake.
It’s the action bias. You’ll all have seen a goalkeeper dive to try to save a penalty and thought that he would have stopped it if he had stood still: a team of Israeli academics has shown that this really is the case. It suggests that we have an urge to do things even if they are counter-productive. In the same way, investors often trade too much and incur excessive fees. They forget that professional fund managers have only a handful of good ideas and that the best stockpickers, such as Warren Buffett and Terry Smith, spend almost no time dealing and most of their time looking for good investments, often in vain. The best active managers are passive most of the time.
Nobody will pay to listen to me playing my guitar. Why, then, should they pay you to do your hobby?
None of this is to say you must switch wholly into passive funds. Momentum and defensive investing both work on average over the long run. And a lot of value investing also pays off, at least during cyclical upswings. And there’s a case for holding private equity and venture capital funds as a bet on the likelihood that a lot of growth will come from outside quoted shares.
Before doing more than this, however, remember that stockpicking is a negative sum game. Dealing costs act like the zero on a roulette wheel; they ensure that players altogether will lose on average. To overcome this handicap you need an especial advantage – knowledge that others don’t have, or a capacity to bear risk that they lack. Do you really have these? Or are you instead committing the errors of which Professor Statman has warned?