Canadian Couch Potato recently posted a thoughtful criticism of Gordon Pape’s argument in favour of active investing. Pape’s reasoning strikes me as another example of what I call the ‘Hail Mary’ argument.
Passive index investors receive market returns less modest costs. Active investors also receive market returns, but their costs are much higher. So, on average, active investors get lower returns than passive investors. This is true whether market returns are high or low.
Despite this argument, which is based on simple math, we often hear people say that when the markets give poor returns, you have to become a stock picker to get decent returns. On the surface this is true. The only way to beat the market is with some active investing approach; passive investors will never beat the market.
However, the average active investor will still lose to the market. A few will beat the market, and most will get less than market returns, even when market returns are poor. For most investors, trying to beat the market is a Hail Mary approach. It probably won’t work, but passive investing is guaranteed to not beat the market.
So, what’s wrong with a Hail Mary? Football teams try them all the time. They’re exciting and occasionally they work. Unfortunately, there is a big difference between football and life. Football teams only try a Hail Mary when it’s the last hope before all is lost. There is no difference between losing with a conservative play and losing with a failed Hail Mary. But, in real life, there is an important difference between getting a cumulative passive return over a decade of 25% and getting an active return of 0%.
The only way it makes sense to use active investing is when there is a reasonable expectation of outperforming passive investing. The investor has to be correct in his belief that he is so much better than other active investors that he will overcome higher investing costs to beat the market. Just hoping to outperform by luck is little better than gambling at the roulette table.