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Personal Finance: In Investing, Winning Means Being Average

Wednesday, March 25, 2015

 

There is a long-running debate regarding whether it is possible for an investor to outperform the broader stock market consistently over time. There are those who believe that there are investors who have an inherent ability to outperform, achieve "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 1926 shows that active management is unable 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 approach" 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.

Investing by buying winning stocks or mutual funds based on past out-performance is akin to buying high and selling low. Empirical data shows that these investments will revert to the mean or even under perform in the future.

Even if we assume that there are gifted managers out there like Peter Lynch and Warren Buffett, it is impossible to identify these managers in advance.  We can only identify them after they have achieved success, which does us little good in making investment decisions in the present.  Peter Lynch could not pick his successor at Magellan Fund to continue his own successful run (remember Jeff Vinik?). What chance do any of us have of doing better? The difficulty of choosing winning managers in advance is also born out by the empirical data which shows that 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 just as likely that these manager's results were due to luck as they were to inherent skill.

Markets work and are highly efficient in reflecting all known information in the current price of securities.  Future price changes are the result of new information which is by definition unknowable in the present.  Trying to predict future market prices is therefore nothing more than gambling, the antithesis of investing.  

In my opinion, the matter has been settled. A passive investment strategy is the only one that makes sense for the prudent long term investor and offers the best chance of earning a market rate of return.  Sure, this means that you forgo the small chance of beating the market over time but the trade off is well worth it.  Owning passively managed mutual funds, such as those from Vanguard or DFA, is the most practical way for individuals to implement a passive investment strategy.

Warren Buffet perhaps put it best when he said “I'd rather be certain of a good return than hopeful of a great one”.  Heed his advice by pursuing average returns and resisting the temptation to swing for the fences.  That is the surest way to achieve long term investment success and realize your lifetime saving goals.

Readers with questions on personal finance and Social Security can email Joe Alfonso at [email protected].

Joe Alfonso, CFP®, ChFC, EA regularly writes on financial topics and is an expert on Social Security planning. He is founder of the Fee-Only financial planning firm Aegis Financial Advisory in Lake Oswego, Ore., and is the principal advisor for the firm. Joe is a CERTIFIED FINANCIAL PLANNER™ professional and an Enrolled Agent, admitted to practice before the IRS to represent taxpayers at all administrative levels for audits, collections, and appeals. He is a member of The National Association of Personal Financial Advisors (NAPFA).

 

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