Chapter 9. Active versus Passive Management
For many investors, the active versus passive debate is the most contentious issue. We will present the evidence and hope you are convinced to follow our recommendation. However, the rest of the advice in this book applies regardless of which strategy you use to implement your investment plan.
There are two theories about investing. The conventional wisdom is that markets are inefficient. Smart people, through diligent efforts, can uncover which stocks the market has under or overvalued. This is called the art of stock selection. Smart people can also time the market, getting in ahead of the bull emerging into the arena and out ahead of the bear emerging from hibernation. This is called the art of market timing. Together, stock selection and market timing make up the art of active management.
The other theory is that markets are efficient, that the price of a security is the best estimate of the correct price: otherwise, the market would clear at a different price. If markets are efficient, and accounting for the expense of the effort, attempts to outperform it are highly unlikely to prove productive.
The debate about which strategy is the one most likely to produce the best results is the financial equivalent of the "Tastes great! Less filling!" debate. Like that debate, it is unlikely to end. While it rages, we can examine the evidence from academic studies, allowing you to make an informed decision on which strategy to adopt.