Whether you’re swayed by the academic theories against active investing – or just the abundant proof showing most fund managers demonstrably fail to beat the market – the case for index investing is overwhelming.

No wonder the lucrative active fund industry has been battling indexing since the latter was introduced in the 1970s.

Jack Bogle, who as the founder of Vanguard group did so much to popularise index funds, even saw his competition decry passive investing as un-American!

It didn’t work.

Today Vanguard is one of the largest managers in the world by assets under management (although crucially, with its low-cost index funds it makes much lower margins on those assets than its more active rivals).

Fidelity, another big player in index funds, is also high up the rankings.

Index funds still on the rise

Yet despite the success of Vanguard, Fidelity, and iShares here in the UK (which is now owned by the giant Blackrock), overall active investing still has a bigger market share than passive investing.

That seems incredible, if you just consider the evidence we’ve seen in this video series from Sensible Investing.

Clearly still more people need to be hear the somewhat counterintuitive case for index funds, as outlined in the next video.

It features loads of different voices, ranging from John Redwood MP to Merryn Somerset-Webb to Monevator favourite Larry Swedroe:

As the video points out, none other than market-beater extraordinaire Warren Buffett has repeatedly made the case for index funds.

Buffett famously said:

“When the dumb investor realises how dumb he is and buys an index fund, he becomes smarter than the smartest investors.”

Most recently, Buffett revealed his wife’s estate would be put into an index fund after he’s passed on.

Just think about it.

One of the world’s greatest active investors – one of the few with any kind of long-term record of success, let alone Buffett’s 60-year streak – is effectively telling you not to bother even trying when it comes to active investing.

It’s a bit like Jamie Oliver telling you to keep out of the kitchen, for your own sake.

Do as he says or do as he does?

I believe that for all his folksy sayings about being greedy when others are fearful and so on, Warren Buffett – an investing genius – knows just how hard it is for most people to beat the market.

Tens of thousands of the world’s smartest and best-paid people still try every day. Most fail after costs.

Will you really do better than them?

If you want to invest actively for some other reason (I pick stocks myself) then fair enough.

But don’t do it because you think you’re the next Warren Buffett, or because you think it’ll be easy to beat all the other wannabe Buffetts out there.

The chances are you won’t even beat Buffett’s best bet – a cheap index fund.

Check out the rest of the videos in this series so far.

Good reads from around the Web.

Since the world’s wealthy are happy to have their funds devoured by the locusts of high-finance – hedge funds and their 2/20% fees – then who knows, maybe they’ll be glad to have their money managed by rats, too?

Enlightenment Economics reports on a curious project to teach rats to trade:

The rats were trained to press a red or green button to give buy or sell signals, after listening to ticker tape movements represented as sounds. If they called the market right they were fed, if they called it wrong they got a small electric shock.

Male and female rats performed equally well. The second generation of rattraders, cross-bred from the best performers in the first generation, appeared to have even better performance, although this is a preliminary result, according to the text.

Marcovici’s plan, he writes, is to breed enough of them to set up a hedge fund.

If you’re thinking you want to get in early – before the best of the rat traders start to demand exorbitant amounts of cheese – you might head to the Rat Traders website to learn more.

Unfortunately you’ll discover that while the idea caught the blogosphere’s imagination this week ¹, the last updates from the site hail from 2009.

Perhaps the rats were blown-up in the financial crisis? Or maybe they turned to teaching or caring for the elderly or some of the other things we were told financial folk were going to do, having seen the error of their ways.

(Until about 2010, when they started making bazillions again.)

[continue reading…]

1. Thanks to Monevator reader G. for putting me on the trail.[↩]

You probably came across the idea of diversification fairly early in your passive investing adventures.

Diversification is an age-old concept, after all.

According to The Bible, King Solomon was advising investors to spread their risks nearly 3,000 years ago:

“Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”

And in the 1600s the first East India companies enabled speculators backing British, Dutch and French adventurists to split their exposure across several of these prototypical limited liability companies – lessening the chances that all your worldly wealth would end up in the hold of a Barbary corsair.

Nowadays it’s easy to achieve wide diversification. Index tracking funds enable you to invest your money across markets and into different asset classes.

A simple portfolio can be created with just a handful of funds, with your precise allocations tweaked to suit your temperament and attitude to risk.

The only pirates you need to worry about are rapacious fund managers!

The theory of investing in everything

It took academia a while to pin down exactly how diversification works, but the now-famed Harry Markowitz got the game going by deconstructing how risk and reward is distributed across portfolios.

The rest is history, or rather Modern Portfolio Theory, as Sensible Investing explains in this video:

Says Art Barlow from Dimensional Fund Advisors:

“Really the cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. Until Harry Markwowitz gave what was almost an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it.

Even though prices don’t move in nice, let’s say, sine-wave fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time.

And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they will ultimately cancel each other out.

And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.”

The final crucial piece of the puzzle came in the 1960s, with William Sharpe and other academics devising the Capital Asset Pricing Model.

No such a Modern Portfolio Theory now

Portfolio Theory and the Capital Asset Pricing Model now underpin most market analysis.

And latterly authors like Lars Kroijer have explained how the model implies that rather than try to pick stocks or invest in particularly skewed funds, ordinary investors are best off holding total market index trackers (something like the Vanguard World Index Fund) for the equity part of their portfolio, and vary their exposure to risk simply with cash and government bonds.

See his book Investing Demystified for more details.

Of course, not everyone agrees with the academics. Warren Buffett is one notable critic of the models.

But even he backs trackers as the best way forward for most investors.

It’s also interesting that many edge-seeking hedge funds start from the premise that markets are overwhelmingly efficient as implied by these theories, and then look for risk/reward discrepancies and mispricings.

Indeed Harry Markowitz himself co-founded one of the very first such quantitative hedge funds!

Check out the rest of the videos in this series so far.