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Fiduciary Focus: Active vs. Passive Investing (Part 2)

Active investing in financial markets is a zero sum game.

W. Scott Simon, 03/30/2005

This month's column continues the series I began last month that explores active investing and passive investing within the context of modern prudent fiduciary investing.

There is widespread belief among investors, repeated endlessly by the investment media, that opportunities to beat the market are greater in "inefficient" markets. Skillful investors are said to have a better chance of uncovering investment "gems" by picking "inefficiently" priced stocks such as small-company stocks and emerging-markets stocks--stocks that most investors "ignore."

The media, though, doesn't tell investors about a much more important story: the critical difference between the (very consequential) fact that active investing in all financial markets is a zero sum game and the (less consequential) belief that a particular financial market is efficient or inefficient. That difference helps explain why passive investment strategies are ordinarily the most prudent for fiduciaries to use not only in efficient financial markets but, surprisingly, in inefficient markets as well.

That Active Investing in All Financial Markets Is a Zero Sum Game Is a "Fact"

A powerful argument in favor of passive investing (particularly germane to fiduciary investors) rests on the simple arithmetic of a zero sum game. It is a fundamental, yet little understood, mathematical fact (not a belief) that active investing in all financial markets such as the stock market in the United States or the bond market in South Africa is a zero sum game.

Game Theory (a branch of mathematics first developed in the 1920s) posits that there are three kinds of games: a positive sum game where, on average, people win, a negative sum game where, on average, people lose, and a zero sum game where some win and some lose but, on average, people break even. Some of the "games" studied by Game Theory are nuclear war, raising children, and investing.

Nuclear war is a negative sum game where all lose. Government think tanks used Game Theory for many years to simulate what could happen in a nuclear exchange between the U.S. and the USSR. (Fortunately, they realized that it was a very negative sum game called Mutual Assured Destruction and decided not to play.) Raising children is a positive sum game in which both parents and children win. It may not seem that way, though, when trying to get the kids to go to bed at a reasonable hour. Active investing--defined as holding any given subset of stocks other than what comprise the market portfolio--is a zero sum game where some investors will win and some will lose relative to the return of the market or a market segment.

Those that participate in a financial market consist of three groups of investors: passive investors who earn the market return, active investors who outperform it, and active investors who underperform it. To avoid confusion, note that the zero sum is not 0 but the actual return of a financial market or market segment. For example, in 1995 the return--as well as the zero sum--of the S&P 500 index was 37.58%.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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