Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

CHAPTER 6

Active versus Passive Investing

LARRY E. SWEDROE Principal, Buckingham Asset Management, LLC, St. Louis

 

 

 

There are two theories about how markets work. The first is that smart people, working diligently, can somehow discover pricing errors that the market makes. In other words, they can discover which stocks are undervalued (GE is trading at 30, but it is really worth 40) and buy them. And they can discover which stocks are overvalued (IBM is trading at 30, but it is really worth 20) and avoid them; or, if they are aggressive they can sell them short (borrow IBM stock, sell it at 30, then buy it back at 20 when the market corrects its error). That is called the art of stock selection.

In addition, these same smart people can also anticipate when the bull is going to enter the arena. They recommend increasing your allocation to stocks ahead of the anticipated rally. They can also anticipate when the bear is going to emerge from its hibernation, and recommend lowering your equity allocation ahead of that event. This is called the art of market timing.

The two strategies, stock selection and market timing, combine to form the art of active management. And active management is the conventional wisdom—ideas that are so accepted by the general public that they go unchallenged.

There is a second theory on how markets work. It is based on over 50 years of academic research. This body of work is known as Modern Portfolio Theory (MPT). A major component of MPT is the efficient ...