September 15, 2024

by Stephen Stofka

This week’s letter is about two different investing styles, active and passive, and how they are affected by the average. The active vs passive debate in investing began several decades ago when John Bogle founded Vanguard as a way for individual investors to invest in a market basket of stocks. The active investor is like a miner panning for gold in a mountain stream. He (mostly male, I think) carefully studies the residue in the bottom of the pan, looking for the glint of gold in the sunlight. Some miners strike it rich while most barely cover the costs of their tools and time. The index investor, on the other hand, buys a share of the company that buys gold from the individual miners.

The core issue in that debate stretches back to the classical period in ancient Greece and the role of our powers of reason. In the following sections, I will rely on some points my wife, Dr. Beth Davies, made to her class this week. For some background, Aristotle was a Greek philosopher who lived and wrote in the 4^th century B.C. Thomas Aquinas was a 13^th century Christian theologian who tried to unite the secular reasoning of Aristotle with the Catholic tenets of faith.

Davies writes “Aristotle places all of his confidence in our faculty of reason. No matter the shifts that our fortunes face in life, we can always apply practical reason and therefore pursue our desired end, which is to flourish (be happy).” The active investor believes that research and reasoning can generate what is known as alpha, the extra return that an investing strategy has over an average that serves as a benchmark.

Davies writes “Aquinas loved Aristotle’s philosophy … but the worldview of his time was saturated with the belief that human nature is inherently sinful,” implying that our sinful desires interfere with our reasoning process. How did Aquinas resolve this dilemma? Davies continues, “He did it by adapting the Islamic idea that human intellect is a natural process. Since God created nature, natural processes are not corrupted by sin. Medieval theologians grouped intellect into this category of ‘natural process.’ Medieval theologians, Christian and Islamic, needed a way to preserve some part of the mind from sin, and since reason can be corrupted by appetite, they settled on intellect.” Having less confidence in their intellectual expertise at investing, the passive investor accepts an average market return and saves both the expense of higher trading fees and their own time.

In Thinking Fast and Slow, Daniel Kahneman noted the many cognitive biases that introduce flaws in our reasoning when we make choices. In recognition of these biases, investment managers have developed algorithmic trading models intended to reduce human error and bias. The execution of those strategies can be tainted by faulty reasoning as well, so investment managers are turning toward machine learning. Criteria like minimum returns and acceptable risk ratios are input into programs which run thousands of simulations on trading data and research to find optimal trading strategies (Hansen, 2020). In a medieval interpretation, these programs are the embodiment of the distinction between intellect, created by God, and corruptible human reasoning.

Most individual investors do not have the time, resources or background to develop or maintain such strategies. In the future, investment managers may offer funds or ETFs that employ such strategies but will charge higher fees for the promise of higher risk-adjusted returns. In an analysis of eight years of market data from 2009 -2017, Prondzinski and Miller (2018) wrote “evidence suggests that active funds underperform index funds by approximately the difference in their costs.” If these strategies do deliver higher returns, more investment firms will use them, raising the average market return and reducing alpha to near zero. Even if short-term returns are higher, a passive strategy should produce returns at least as good as many active strategies.

Indexes rely on the power of the mean. There are several ways to compute an average, or mean, but the most common is the arithmetic mean, determined by the sum of the data divided by the number of data points. Few if any data points match the average, yet it is a benchmark concept in statistics, forming the basis for many calculations like variance and standard deviations. Index funds rely on the Law of Large Numbers, creating a sample of a large dataset filtered by some criteria like market capitalization. Unlike machine learning, the filter criteria is not a dynamic optimizing strategy but a characteristic of the market. It is less dynamic but a “good enough” strategy that minimizes costs.

To Aristotle, the virtuous mean was a behavioral phenomenon where an individual used their reason to compromise between extremes of action. On a highway, some drivers are weavers, changing lanes frequently in the belief that an optimizing strategy will get them to their destination sooner. Some drivers keep to one lane, going with the flow and making few changes until they approach their exit. At the exit, they experience a sense of satisfaction upon finding that they are only a few cars behind a weaver. That is index investing.

//////////////////

Photo by StellrWeb on Unsplash

Keywords: passive investing, active investing, alpha

Hansen, K. B. (2020). The virtue of simplicity: On machine learning models in algorithmic trading. Big Data & Society, 7(1), 205395172092655. doi:10.1177/2053951720926558. Available from: https://journals.sagepub.com/doi/full/10.1177/2053951720926558

Prondzinski, D., & Miller, M. (2018). Active Versus Passive Investing: Evidence From The 2009-2017 Market. Journal of Accounting and Finance, 18(8). https://doi.org/10.33423/jaf.v18i8.114