For the average investor, myself included, the best long-run investment strategy to create wealth is a passive strategy. In contrast, active managers attempt to “beat the market” and earn what investment professionals call “alpha.” They do this in a couple of ways. One, known as “market timing” involves changing asset allocations in an attempt to guess when the stock market is going to move up or down or when interest rates are going to change. The other involves “security selection” and searches for stocks or bonds that are mispriced. A variation of the two is called “sector rotation” and involves selecting specific market sectors in which to invest.
A passive strategy, also known as indexing, simply attempts to capture market returns at the lowest possible cost. In practice, this means the average investor should first decide how to allocate her money between equities and bonds (fixed income), assuming she already has some cash stashed away. Then she selects investment products that will capture as much of the whole equity and bond market as feasible. Index funds were the traditional way to do this, and now Exchange Traded Funds (ETF’s) accomplish the same, but at lower cost.
I have a PhD in Finance and hold the CFA designation, which is focused precisely on portfolio management and security valuation. Why then, given my seemingly comparative advantage in understanding markets and securities, would I choose a passive strategy? Well, it’s really pretty simple. In the aggregate, everyone cannot beat the market because everyone is the market. In the aggregate “alpha” must be 0, and after investing costs, alpha is negative. Does this mean active management and managers are bad? No, not at all. Active managers help make markets efficient. It is just that we have no way of knowing, ahead of time, which managers are going to do well and which aren’t.