Should you be an Active or Passive Investor? By Professor Aswath Damodaran.

Summary

The video explores the debate between passive and active investing, tracing its roots to key figures like Gene Fama and Jack Bogle. Passive investing, through index funds and ETFs, has grown significantly, outperforming active investing over the last decade. Active investors, burdened by higher costs and inconsistent results, often fail to beat the market. While some defend active investing, citing successful outliers like Warren Buffett, the video highlights the overall dominance of passive strategies. It concludes with the notion that investing should be personal, emphasizing the enjoyment and belief in one's approach, rather than purely financial gains.

Takeaways

• 📈 The debate between passive and active investing has been ongoing for over 50 years.
• 🏆 Eugene Fama's 1971 work on efficient markets laid the foundation for passive investing, leading to his Nobel Prize in 2013.
• 📊 Since 2005, passive investing has significantly grown, with its share of institutional money doubling from 20% to 40% by 2016.
• 💼 Passive investing outperforms active investing, with active investors generally underperforming the market due to higher costs.
• 📉 Over various time periods (1 year, 3 years, 10 years), passive investors consistently outperform active investors.
• 🧐 No specific investing style (e.g., value, growth, small cap) has consistently beaten passive index funds over time.
• 📉 Even superstar funds and managers often fail to consistently outperform the market year after year.
• 🔍 Passive investing reduces the role of corporate governance oversight, but activist investors (like Carl Icahn) remain involved.
• 🚀 Fintech and disruption in the financial industry are expected to shrink the role and profitability of active investing.
• 😊 The speaker remains an active investor, not due to superior information, but because of personal enjoyment and faith in the process.

Q & A

What is the main debate discussed in the video transcript?

The main debate is whether investors should adopt a passive investment strategy, by using index funds and ETFs to match the market, or pursue an active investment strategy, trying to beat the market by picking stocks and timing investments.

Who is Professor Gene Fama, and what is his role in the debate on passive vs. active investing?

Professor Gene Fama is a key figure in the development of efficient market theory. His 1971 paper laid the groundwork for the belief that markets are efficient, which supports the argument for passive investing. He won the Nobel Prize in 2013 for his work.

How did Jack Bogle contribute to the rise of passive investing?

Jack Bogle is credited with creating the first index fund, the Vanguard 500 Index Fund, in 1975. Despite initial skepticism, this fund laid the foundation for the growth of passive investing, making Vanguard one of the largest fund families globally.

How has passive investing grown relative to active investing since 2005?

Since 2005, passive investing has grown significantly, doubling its share of institutional investments from less than 20% to nearly 40% by 2016. Funds have increasingly flowed into passive investments while moving out of actively managed funds.

Why is it impossible for active investors as a group to consistently beat the market?

It is impossible for active investors collectively to beat the market because passive investors, who make up a growing share of the market, essentially match the market returns. Active investors face higher costs due to transaction fees and other expenses, which leads to underperformance relative to passive investors.

What evidence suggests that active investors underperform compared to passive investors?

Data from various time periods, such as 1-year, 3-year, and 10-year spans, consistently shows that active investors underperform passive investors. For example, in 2015, passive investors earned 0.99% returns, while active investors lost 1.93%, a difference of 2.92%. Over a 10-year period, active investors underperformed by 1.21% annually.

Do certain styles of active investing, like value or growth investing, outperform passive investing?

No. Across different styles of investing, such as value, growth, and small-cap investing, data shows that active investors consistently underperform compared to their passive counterparts. For example, small-cap growth investors earned 3.44% less than those who invested in a small-cap growth index fund.

Is active investing more successful in emerging markets compared to developed markets?

Active investing shows slightly better performance in emerging markets, such as India, but even there, passive investing often outperforms over longer time periods. The outperformance of active investing in these markets is not significant enough to reverse the overall trend in favor of passive strategies.

Why might picking superstar fund managers not guarantee future outperformance?

Superstar fund managers often fail to maintain their performance in subsequent years. Data shows that top-performing managers in one period are more likely to be among the worst performers in the next period due to the high risk they take, which leads to inconsistent results.

What are some potential downsides of passive investing?

Critics argue that as passive investing grows, corporate governance might suffer, as passive investors do not actively engage in managing companies. Another concern is that with fewer active investors gathering information, market prices could become inefficient and noisy. However, this is considered unlikely, as the need for information would eventually incentivize some investors to collect it.