There exists a long-running debate regarding whether it is possible for individual investors to outperform the broader stock market consistently over time. On one side are those who believe that there are investors who have an inherent ability to outperform, add “alpha” is the expression, through shrewd stock picking and correct forecasting of future market trends. This camp believes in “active” management.
There is another group, led by academics such as Eugene Fama and Kenneth French, who believe in a “passive” investment approach. They feel that market data extending back to the 1800′s shows that active management is not able to consistently outperform over time, especially when the real world costs of taxes and investment fees are considered. The passive camp argues for a “buy and hold” strategy and believes that owning a highly diversified portfolio designed to track the performance of the overall market is the most rational approach and the one that has been shown to outperform active managers even over shorter periods of time.
I am firmly in the camp of passive investing.
Buying into an active manager based on past positive performance is no different than buying high and selling low. The likelihood is that the manager will revert to the mean or even under perform. In reality, your likelihood of identifying a manager BEFORE THE FACT who will outperform the overall market over time is low to nil. And the percentage of managers who outperform over time is no more than what one would expect in a standard distribution of total performance. It is therefore hard to say that these manager’s results were the result of inherent skill as opposed to luck.
Even if we assume that there are gifted managers out there like Peter Lynch and Warren Buffett, it is impossible to identify these managers before hand. Peter Lynch could not pick his successor at Magellan Fund to continue his own successful run (remember Jeff Vinik?). What chance does any of us have of doing better?
In my opinion, the matter has been settled. A passive investment strategy is the only one that makes sense and that is consistent with a fiduciary standard. It is the approach that I take with my own investments and adhere to when managing the assets entrusted to me by my clients. This approach also recognizes that the main value that I provide comes from a comprehensive approach to financial planning and a focus on enabling clients to achieve their key life goals. In my opinion, that is the only kind of “alpha” worth pursuing.