The logic of passive investing is undeniable. For many, the debate between passive and active ended long ago, with passive the unquestioned winner.
We recognize this reality. This article is not meant to convert a passive investor into an active investor. However, we do explore why we believe some active investing approaches can beat passive strategies over a reasonably long time horizon.
Our framework is meant to help investors decipher the so-called factor zoo to determine if an active strategy may be sustainable or is likely a pipe dream. More broadly, this piece can be thought of as merely an introduction to the argument for the possibility that active management can work. For an in-depth look at our sustainable active investing framework, you can view the extended version of this piece here.
How do we determine if an active investor will be successful? We believe that having superior stock-picking skills, amassing an army of Ph.D.s to crunch data or simply being smart are not, by themselves, sufficient to ensure active investing success. We need something more.
We propose that to achieve sustainable success as an active investor, analytical skills are less important than: 1) an understanding of human psychology; and 2) an appreciation of market incentives (behavioral finance), which, when combined, give rise to the possibility of beating a passive approach. We start our discussion with one of the original minds in the “emerging” field of behavioral finance—John Maynard Keynes.
John Maynard Keynes, a shrewd observer of financial markets and a successful investor, highlights the paradox that behavioral finance represents. At one point, Keynes was nearly wiped out while speculating on leveraged currencies (despite being a highly successful investor). This downfall led him to share one of the greatest investing mantras of all time:
“Markets can remain irrational longer than you can remain solvent.”
Keynes’ quip highlights two key elements of real-world markets that the efficient market hypothesis doesn’t consider: Investors can be irrational, and arbitrage is risky.
In academic parlance, “investors can be irrational” boils down to the recognition of a role for psychology in markets. “Arbitrage is risky” boils down to what academics call “limits to arbitrage,” or market frictions. These two elements—psychology and market frictions—are the building blocks for behavioral finance (depicted in Figure 1, below).
Figure 1: The 2 Pillars Of Behavioral Finance