Active and Passive Investing

In a previous post I argued that the debate over the New Zealand Super Fund was leading to a recurrence of popular misunderstandings about financial markets, particularly with respect to 'timing' or 'beating' the market.

A fallacy I didn't address, but perhaps should have, was the (related) idea that now is somehow a 'good' time for active investing - that by picking stocks that you suspect are going to rebound in terms of price, there is an opportunity to make a lot of money, rather than just riding up the market by buying indices or something similar. A lot of people seem to believe this is the case with the New Zealand Super Fund.

Here, Kenneth French explains why this is wrong. Consider two types of investment strategies - active investment and passive investment. Active investors try to time the market, pick under-priced stocks, etc. Passive investors just have portfolios that represent the market, so when the market as a whole goes up so does their portfolio, and when it goes down their portfolio goes down. When you phrase it like this, it is clear that both groups have to have the same returns on average. Passive investors' returns obviously average out at market levels. The market is only made up of active and passive investors, so active investors have to average out the same as well! However they usually charge higher fees. So in fact now, like every year, is a bad time for active investing.