The Active Vs. Passive Debate Explained

Berkshire Hathaway recently released its most recent (2016) annual shareholder letter and every retail investor in the United States freaked out that Buffett, the ultimate beat-the-market investor has switched sides and joined the passive investing team.

For those that aren’t familiar with the active vs passive debate, let me briefly explain.

The beliefs of investors can be broken down the beliefs of investors into two camps:

One camp argues that the market is “informationally efficient,” means that the price of a stock (or any other investment asset) incorporates all relevant and available information, and thus will accurately reflect its true or intrinsic value. According to this theory, short-term fluctuations of a stock’s price above or below its intrinsic value will be random and unpredictable. Changes in a stock’s intrinsic value are also random and unpredictable because they will be based on future developments and new information that are impossible to anticipate. In a 1965 article, Fama described what he called the “random walk” behavior of stock prices.

The upshot for the investor? If the Efficient Market Hypothesis is true, then consistently outperforming the market is extremely unlikely and, in the long run, nearly impossible.

The other camp takes findings from psychology and other social sciences and applies them to how people make economic decisions both in general and in the stock market. One of the leaders in the field is Daniel Kahneman, who sums up his research (alone and with others) in the book Thinking, Fast and Slow. Supported by a wealth of detailed behavior studies, Kahneman argues that most of our decisions are a result of a fast and intuitive thought process that is very easily colored by emotions and unconscious bias — and that even the judgments of our slow, rational side are influenced by the assumptions of our intuitive side.

According to this view, since participants in the market are anything but rational, the market is anything but efficient. Those arguing against a rational market seem to be gaining the upper hand in the debate. Kahneman also won a Nobel Prize for Economics, and others like Robert Shiller (Irrational Exuberance), Richard Thaler (Misbehaving: The Making of Behavioral Economics), and Justin Fox (The Myth of the Rational Market), building on his work, contend that the ups and downs of the stock market in recent decades are more pronounced and volatile than should be the case if the Efficient Market Hypothesis was true.

Although it’s overly simplistic to reduce the vast and varied world of investing to these two schools, in practice, the line between them is often blurred. And as an individual investor, you don’t have to make an either/or choice between them. Strict EMH adherents concede that it is possible to beat the market at the margins, and contrarian investors (like Warren Buffett) acknowledge the merits of passive investing.

But if it’s a simplification, it’s a useful one. Beneath all the number-crunching, investing is ultimately a question of philosophy. There is no one correct path but the most successful investors have a coherent philosophy and stick to it. These two points of view — of a rational market that one can at best hope to ride, and of an irrational market that is beatable — are the North and South poles of investing philosophy. And, as you begin your investment journey, you’ll see how these contrasts play out in very different approaches to two key questions faced by every investor: managing risk and diversification.