The Modern Portfolio Theory -- for which three financial economists were awarded a Nobel Prize -- defined a way to effectively capture market returns through passive asset class investing. In doing so, passive investors can expect to outperform most other market players who are attempting to actively outperform the market.
Does active investing (or stock picking) work?
All information about the problems of stock picking is overwhelmingly in favor of passive investing. That's what Larry Swedroe, director of research at BAM Advisor Services and author of "The Only Guide to A Winning Investment Strategy You'll Ever Need: Index Funds and Beyond --The Way Smart Money Invests Today, " says.
Swedroe compares passive asset class investing to playing tennis. Consistently successful investing requires a consistently successful strategy. Active managers will lose more often then they will win. To win in tennis, you should just hit the ball safely back.
The starting point for implementing the winning investment strategy is passively managed funds, such as index funds. An index fund gets you an expected market rate of return in a tax-efficient manner. A portfolio of broad, global, diversified index funds for a long investment horizon can provide faith that the markets work.
Nobel Prize Laureate Merton Miller has said that in a random and efficient stock market, active investors are just gambling.
Academics have essentially proved that active fund management is a loser's game. The vast majority of active funds underperform passive benchmarks. So the vast majority of buyers of active mutual funds pay billions of dollars in exchange for, at best, nothing.
Do winners repeat?
No.
Study after study shows that mutual funds that have performed well in the past will unlikely to continue to outperform. Mutual fund tracking services, periodicals and Web sites regularly publish lists of top-performing funds. Since past performance does not predict future performance, this information is of little use in selecting mutual funds.
John Bogle, founder of Vanguard, was quoted as saying, "No matter where we look, the message of history is clear. Selecting funds that will significantly exceed market returns, a search in which hope springs eternal and in which past performance has proven of virtually no predictive value, is a loser's game."
Burton G. Malkiel, author of "Random Walk Down Wall Street," has said that most investors would be considerably better off purchasing a low-expense index fund, rather than trying to select an active fund manager who appears to possess a "hot hand."
Henry Blodget, a former Internet analyst at Merrill Lynch, now a financial writer said, "On average, active funds underperform passive funds by about a percentage point a year (or more). Over 20 years, assuming 10 percent annual appreciation, this difference will eat nearly a fifth of your return. Over 40 years, it will gobble almost a third."
A CPA advisor does have a fiduciary duty. When helping a client choose funds, recommending active funds, without promoting cheaper and probably superior passive alternatives may be a breach of fiduciary duty.
As a fiduciary, it is not enough to act in your client's best interest. You must also be able to prove to a court that you have done what a "prudent man" would have done. Much of my work has centered on helping financial advisors build dream practices.
That means you must fulfill your fiduciary responsibilities.
Phyllis Bernstein CPA, is president of Phyllis Bernstein Consulting Inc., in New York (
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