Thursday, December 16, 2010

Index Investing is a Statement about Personal Limitations

There is no shortage of lively debate about the merits of passive index investing versus active stock picking. Much of the discussion stems from one side misunderstanding the other. After reflection, I’m convinced that my choice to invest passively in index ETFs is fundamentally a statement about my own limitations.

I don’t doubt that there are stock pickers who outperform due to skill rather than luck. It seems clear enough that Warren Buffett did this throughout his career, although it's not clear whether he can continue to outperform in the future given the huge 12-figure sum he is trying to grow.

I don’t try to pick individual stocks because I don’t believe that I can beat the index consistently after costs. Proponents of active investing would be quick to point out that I can just find someone who can outperform at stock picking and invest in this money manager’s fund.

This brings me to my next limitation: I don’t believe that I can figure out which money managers will outperform. There are a few people in the active investing world I admire such as Tom Bradley at Steadyhand. However, I don’t know if they have an above-average chance to outperform. This is a statement about my limitations and not a statement about Steadyhand. Their approach to investing seems sensible and I like the way they control fees, but I still don’t know how likely they are to outperform indexes.

Maybe it isn’t even necessary to pick winning money managers. Maybe I can just find a financial advisor who can pick winning money managers for me. As you might guess at this point, I have a third limitation. I don’t believe that I can figure out which advisors can pick winning money managers.

All this sounds very weak. Am I just lacking in confidence? Those who know me well know that I have no shortage of confidence. I spent several years working with financial advisors, and then several more years picking my own stocks. My conclusion is that it is a very difficult game and I can’t do it well enough to overcome the costs of these approaches.

To those who believe they can pick winning stocks or pick winning money managers or pick advisors who can pick winning money managers I say that the vast majority of you are wrong. This doesn’t mean that you are all wrong. Maybe some are right. But I can’t tell which ones. The fact that most people whose money is actively invested will get returns below index returns is just simple math. Rather than restate the explanation of this fact, I’ll just point to William F. Sharpe’s explanation.

So for those convinced that they have skill at picking stocks, money managers, or advisors, you can pity the thundering herd of those who cannot. But know that I think the odds are strong that you are actually running along with the rest of us.


  1. Maybe it's because I'm not a people person, but I would think it would be much easier to pick stocks than to pick managers or advisors...

    I suppose I'm arrogant enough to have an active portfolio alongside my indexed one. So far, I have outperformed, but I also personally doubt that I'll be able to keep that up, in part because as the market comes out of crisis mode there are fewer inefficiencies to find.

  2. Some people don't know any other way. Someone recommends a stockbroker, and not even knowing what due diligence means, they sign up for life.

    And that means they will own mutual funds with a sales load.

    I'd bet anything that the majority of mutual fund holders believe their brokers are smarter than they are - would not cheat them - and don't understand that those loads and management fees are killing their portfolios.

    You can try, but those people are not reading your blog and are unlikely to understand active vs. passive investing.

  3. @Potato: There are those who say that it's easy to pick winning money managers as well. If I have any temptations it's on the stock-picking side.

  4. @Mark: You're right that most people have little idea of what their advisors do and don't know. I'm not worried about saving the world. I just want to improve my little corner of it.

  5. I think your assumptions are safe. I'm sure there are a lot more people who think they can pick stocks/managers/advisers and actually can't, than think they can't and actually can.

  6. A humble admission Michael. I same the same sentiments.