Final Expert Article

Remember last thanksgiving dinner when your uncle, Bob, wouldn’t stop talking about his 401k?

There’s more to that picture than you would think. Financial markets, such as the stock market, are complex instruments that allow investors to achieve return by taking risk. At its core, investing is purchasing stocks (or assets) traded on financial markets to achieve future earnings (or returns) on that investment. World famous investor, Warren Buffet, describes investing as “the process of laying out money now to receive more money in the future”. Investing can be traced back to when Europeans needed to finance their colonial expeditions to the new world in the 1600s. Explorers needed to fund the ships, cargo, and crew they needed for their voyages. Expeditions to the New World offered the potential of discovering riches or spices. At the same time, expeditions risked failing, either by sinking of the ship or failure to find wealth abroad. The early investors who financed these explorations balanced risk and return when making their decisions. They shouldered the economic risk of the expedition failing for a percentage of the profits if it were successful. These tradeoff between risk and return still governs investment decisions today.

Uninformed Buyers

When your uncle Bob complains about “losing 10% of his portfolio because of ****ing Donald Trump”, he is talking about risk and return, even if he doesn’t know it. When an investor invests in the stock market, they take risks for potential return. The more risk an investor takes, the higher potential return they can achieve. Your uncle, like most individual investors on the market, likely did not research his stocks or investment options fully before investing in them. This is a market inefficiency, in that buyers who don’t understand what they are buying are inflating the price of a stock. This is both bad for your uncle Bob and all other investors. Bob probably picked his stocks based on the news on Marketwatch or CNBC. These sources provide public information available to all individual investors (and all investment banks hours or days before being public). Therefore, by the time Bob read the article and bought his stocks, the stocks prices would have already been inflated by individual and institutional buyers. A week later, when Bob checks his 401k, he’d realize that the stock fell 5% for no apparent reason. This is because Bob bought the stock when it was too “overbought” by funds, banks, and individual investors.

Individual investors are at a disadvantage because they are usually the last to receive new information.They tend to buy overhyped stocks late and sell early when there is bad news. Therefore, investing individually in specific stocks is usually a bad decision. Unless your uncle Bob has the time and resources to research every stock more in-depth than professional analysts, it is unlikely his 401k will beat the overall market return. If Bob can’t beat the market by picking stocks, what should he invest in? Investors aim to have the best return on their investment for the least amount of risk. By matching the market return through an index like the S&P 500 ensures that you match the market return with the same amount of risk.

Passive Investing

By investing in a passive index fund, like the S&P 500 iShares ETF ($SPY), investors can match the overall market return. The market return, essentially, is the performance of the overall stock market. The S&P 500 consists of the stocks of the 500 largest companies in United States. They are weighted in a theoretical portfolio, or index, based on the size of the company. Therefore, larger companies (with a higher price) are have a larger weight than smaller companies. Individual investors that invest in passive funds achieve the market rate of return, all while paying a minimum in fees and reserving the ability to quickly sell (liquidate) their position. This is advantageous for investors because they achieve the market return without paying high fees or risking being unable to sell their investments (liquidity risk).

However, passive investing strategies buy and sell stocks indiscriminately.This means that when an investor invests in a passive investment vehicle (or fund), the vehicle will purchase all the stocks in the index proportional to its size. The opposite happens when investors exit their passive investing positions. Because of this, a large part of the market is buying/selling stocks with no regard to the specific stock’s fundamentals or value. This results in over-bought and over-sold companies. Currently, roughly 30% of the stock market is owned by passive investment funds. This creates a market inefficiency that investors can exploit. Broad market selloffs trigger passive investment funds to oversell companies and vice versa. Intelligent investors can spot high-quality stocks oversold by passive funds and buy them to increase their returns. So, when your uncle Bob spends two hours a day reading market news, he could be analyzing oversold stocks to find his own stock picks. However, if Bob doesn’t have any finance or business background, or can’t commit his time, he would be better off investing in the passive index, like the S&P 500.

Risk and Return

Bob’s goal, just like all investors, is to maximize return while minimizing risk. With this in mind, passive investing is a valid option for him. He will lower his risk through the diversification of investing in the whole market rather than one specific stock. However, he will only achieve the market rate of return. This is no better than how other investors will perform in the market. If Bob is well-informed, he may take on more risk by investing in individual stocks. To maximize his return with this strategy, he will have to exploit market inefficiencies. By doing his independent research and due diligence, Bob can beat the market return. However, he will be taking on more risk and must rely on his time and effort researching stocks and the market. Active investing isn’t for everyone. Most individual investors are better off investing passively or through a manager. However, there are many market inefficiencies other than those discussed above. If an active investor takes time to research and exploit them, they can make a considerably higher return than their passive peers.