Category: academic approach to investing

Why Active Investing is a Negative Sum Game

In this article well known academics Eugene Fama and Kenneth French reflect on Nobel Laureate William F Sharpe’s 1991 article on the arithmetic of active fund management. This has already been discussed on this blog and you can see a copy of that article here

Cutting through the slightly complex jargon that is used by Fama and French,the essence of what they are saying is that the combined portfolios all active investors have the same weighting in shares as the market as a whole. This means that the combined portfolios can only perform the same as the market, less their costs. It also means that the only way in which an active investor can outperform the market is to do so at the expense of other active investors.

In contrast, passive investors also all hold the same weighting in shares as the market as a whole. This means that their portfolios should perform the same as the market, less their costs. However, as their costs are less than those of active investors, passive investors as a group must outperform active investors.

This article does not seek to deny that some active investors do outperform the market. It is just that their gains have been made at the expense of other equally clever active investors. Other research has shown that winners tend not to repeat and that on the whole, they do not tend to remain winners for very long.

When considering whether to invest actively or passively you have to answer the question ‘Are you feeling lucky?’ For active investors the answer must be ‘Yes’ – in the face of the evidence. For passive investors the answer is ‘No – but at least I will be assured of returns that essentially replicate the market less my costs which are substantially less than for active portfolios’.

From a financial planning point of view, investing should not be seen as a game. Investments are not an end in themselves. Instead they are the means by which individuals fund for the serious financial goals, which they need to achieve in order to lead the future lifestyles that they desire. Speculation on which fund manager is likely to provide better returns than another, in the face of evidence that this is likely to be an unsuccessful strategy, has no place in this process.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

The Arithmetic of Active Management

In the video featured below, Professor Kenneth French mentioned the paper written by Nobel Laureate Economist William F Sharpe. Well here it is.

This type of information needs to be seen in a completely different light to what those of us who are more enlightened call financial porn because it is the informed view of a very highly rated and acclaimed academic. Unlike fund management companies who pump out marketing material designed to entice unwitting investors to part from their money William F Sharpe and others like him have spent decades trying to get to the truth. They have no axe to grind.

The question you have to ask your self is, Do you want to be one of the (as William F Sharpe puts it) “individual investors … foolish enough to pay the added costs of the institutions’ active management via inferior performance“. Of course there is also the famous Dirty Harry saying “What you want to ask yourself is … Are You Feeling Lucky?

For more information on William F Sharpe see this

Stock Picking v Index Investing

I have just found this extremely interesting video link which shows Professor Kenneth French talking about Stock Picking and Index Investing. He explains, far better than I ever could, how stock picking is essentially a fools errand … but a very necessary one which enables those of us with more sense to take a cheap ride on the increased market efficiency which their zero sum strategies create. He also makes some very interesting comments about Hedge Funds.