January 14, 2009

Passive/Active Index Investing

I just don't understand the attraction to passive or active index investing ever since index investing gets so popular. The idea is simple enough; use only broad-based index funds and always stay invested. The proponents of passive investing believe that active management cannot reliably beat the market and they always have plenty of data to back up the theory.

Stock indexes have always been an indicator of the broad market movements that affects all stocks simultaneously. Mutual fund managers traditionally compare their performance against that of a stock index. Hence the term "beating the market". Around forty years ago, some very intelligent people thought it will be easier to start a fund that mimics the performance of stock indexes instead of trying to beat it.

And this was how index funds came about.

Picture Source: www.dailyreckoning.com

However, the whole deal about "investing in the market" hinges on the crucial assumption that the stock market tend to go up over time. How can we be sure that this remains true in the future?

For centuries, Europeans believed that all swans were white until black swans were discovered in Australia. Likewise, we have always assumed that stock indexes tend to rise in the long run (and hence are great long term investments) until we saw data on the recent S&P 500 and that of the Nikkei index.

Given that many economists, including Nobel Prize winners, advocate a index fund approach to stock investing, I certainty wouldn't say it's a FALSE theory.