Debating which investing style, passive or active, is the superior method is unlikely to end soon. The research is too conflicting and exceptions still exist. The difference of opinion has a long and acrimonious history – and it continues to this day. Before we enter the debate and provide some opinions, it is important to define what is meant by passive and active.
Active Investing or Active Management: I’ll start with active as it is easier to define and it is an investing style that is used by the vast majority of investors. Active money managers and investors operate on the belief they can select individual stocks or active mutual fund money managers and do it better than other investors. Evensky writes in Wealth Management, “Active Management is the art and science of security selection based on a belief in a manager’s ability to consistently and accurately evaluate current and/or future events better than other investors. The core philosophical basis is that by brains, hard work, and/or technology the active manager can, over time and net of costs, beat the system. As selecting one asset class in lieu of another is an “active” decision, market timing and active asset allocation are subsets of active management.“ Based on the above definition, it is easy to see why most investors fall into the active management class of investors.
Passive management is a little more difficult to define. Evensky does us a favor by breaking the discussion into index investing and passive investing. Quoting from his Wealth Management book, Evensky writes the following.
“Passive management is the antithesis of active management. Its core philosophical tenet is that by brains, hard work, and technology, a manager cannot, over time and net of costs, beat the system; he can, however, beat most active managers. Passive management is often assumed to be the equivalent of index management. It is not. Index management is a special subset of passive management. A passive manager may make active trading decisions. His decisions, however, are based on information currently available to all investors, not on an ability to read between the lines or predict future trends and events. Index management is passive management with the added constraint that the manager does not make active trading decisions.
The notion that active managers cannot beat the market dates back to the 1950s and the rediscovery of the concept of market randomness. It was propelled by the work of Gene Fama in the late 60s.”
There are a number of books one can read to learn more about active vs. passive management. I’ll suggest three that are very readable.
- The 3 Simple Rules of Investing: Why Everything You’ve Heard About Investing Is Wrong – And What To Do Instead by Michael Edesess et. al.
- The Elements of Investing by Burton Malkiel and Charles Ellis
- The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything In Between by William J. Bernstein