“For most small investors who don’t have time to research individual companies, cheap index funds (i.e. passive investing) are the best way to invest in the stock market.” Does this phrase sound familiar? This was spoken by the world’s richest investor, and reiterated more than once. Is passive investing only applicable to small investors? Does that mean that investors who have time to research individual companies should employ active investing?

Let’s look at some statistics

With reference to Table 1 below, it does not bode well for active investors. Over a one year, three year and five year period, equity indices have handily beat active funds. For example, over a five year period, 72% of the active managers in the “All US Large Cap Equity Funds” failed to outperform the S&P 500.

Table 1: Percentage of sample equity indices that outperformed active funds

In addition, Burton Malkiel, author of the popular book “A Random Walk Down Wall Street” argues that the patterns of asset prices are typically random and one cannot consistently perform better than market averages. He adds that there may be a small number of funds which can outperform the index over the long term but it is statistically unlikely that an average investor can pick those funds.

Another point which proponents for passive investing usually points out is that typically, 80-90% of the returns comes from asset allocation, and the balance comes from stock selection. In layman terms, this means that if you happen to be in the right asset class (for example, equity) at the right time, you can literally close your eyes and buy any equity and you should register gains. Furthermore, there is no guarantee that the returns which come from stock selection will be positive but it is almost a given that the expense ratio for such funds will be higher than that of the index funds.

So is the battle lost for active investing?

Although the statistics above swings the pendulum of favour to passive investing via index funds, it is important to consider the other perspective before we reach a conclusion.

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Table 2: Berkshire’s Corporate Performance vs the S&P 500

Table 2 shows Berkshire Hathaway returns vis-à-vis the S&P 500. It is indeed staggering that from 1965-2008, investors who invested in Berkshire Hathaway would have reaped a compound annual growth rate of 20.3% as compared to 8.9% in S&P 500.

Although critics will rightly point out that not everybody can emulate Warren Buffett’s phenomenal performance, I believe active investing still plays a role in portfolio strategy. I will briefly go through the ingredients to give active investors an idea on what he or she has to do to increase the probability of outperforming passive investing.

Ingredients for a higher probability of active investing success

a) Interest

One has to have the interest to study the economy (at least where the company has the main business exposure), the industry and the specific company (i.e. fundamental analysis). For the company, he should be able to evaluate the quantitative and qualitative aspects of the company. Examples of these aspects would be financial statement analysis, value chain analysis etc. In addition, he should read widely on industry websites, analyst reports and even rumours and form his own judgement after serious contemplation. Furthermore, besides fundamental analysis, he should be willingly to read up on technical analysis, as well as portfolio construction and risk management.

b) Competency

Readers would have noticed that point a) covers a multitude of areas whereby it is unlikely that one will start off having competency in all areas. Thus, he has to acknowledge the areas where he is weak in and brush up those weaknesses, either through reading, seminars, discussion with like minded experienced investors and learning from mistakes.

c) Time

To do points a) and b), one has to have time to devote and build mastery in this. In addition, experience comes from the passage of time, thus if one is unwillingly or unable to devote time to points a) and b), it might be better to engage in passive investing instead.

Conclusion – Choice is yours

The above ingredients are by no means exhaustive. It is provided to give readers an idea on what he has to do in order to achieve a higher rate of success. If the above abridged list of ingredients seems too onerous on readers, it may be a good idea to adhere to passive investing.