Skip to Content
ETF Specialist

Why Passive Investing Makes Even More Sense in Inefficient Markets

In an efficient market, your expected losses are whatever fees you pay. In an inefficient market, your expected losses include returns you give up to faster and better investors.

Passive investing makes a lot of sense in efficient markets. After all, if trying hard isn't going to get you ahead, you might as well diversify as much as possible and keep costs low. But, counterintuitively, passive investing makes even more sense in inefficient markets.

Imagine there are only two kinds of investors: skilled and unskilled. In a perfectly efficient market, this distinction doesn't matter--by definition, everyone has the same expected return, before fees, for any given level of risk assumed. The winners are the ones who give up the least amount of market returns to frictional costs. In a perfectly inefficient market, everyone's expected return is purely a function of their skill. The most extreme version would be a market where one person is so skilled he reaps all the excess returns at the expense of all other players.

To view this article, become a Morningstar Basic member.

Register for Free