How Markets Work
Throughout the world, financial markets historically reward investors for the capital they supply. According to financial theory, freely functioning markets accurately set securities prices so investors receive reasonable rewards for taking long-term risks. These rewards do not come from choosing the right stocks or selecting the best time to enter and exit the market. Rather, investors are rewarded for taking risks that bear compensation and choosing how much of those risks they can afford to take. Specifically, it’s the structure, or asset mix, that on average explains no less than 96% of the variation of equity returns among fully diversified investment portfolios. In other words, the amount of return, typically due from stock selection and market timing is insignificant (Brinson, Hood, and Beebower 1986).
Traditional active stock and bond managers, the type most advisors recommend, strive to beat the market by trying to predict the future. They may bet on certain asset classes, individual companies, countries or industries, or decide to opt out of the market, or a segment of the market, temporarily. As new information arises, buyers and sellers make judgments about how the news will affect a company's future earnings and risk. Market forces move stock prices toward an equilibrium that balances the collective opinions of all market participants. When research predictions go wrong, active investors miss important returns by holding the wrong stocks at the wrong time, or by being out of the market entirely when prices surge forward. Decades of independent research demonstrate that trying to outperform the market with traditional approaches is a poor use of resources. Without insider information, markets are too efficient and unpredictable for any investor to consistently outperform market indexes.
For passive and index portfolio managers like Cardiff Park, the burden of creating returns is removed from the research process and returned to the responsibility of the market, which sets prices to compensate investors for the risk they bear. Passive investment management is a smarter strategy because it acknowledges that returns come from risk and that long-term gain is rarely accomplished without taking a chance. Since not all risks carry a reliable reward, passive managers counsel their clients to invest in stock and bond index funds which avoid risks that don’t generate expected return. These risks include holding too few securities, betting on countries or industries, following market predictions, or speculating on “information” from rating services.
For passive managers the idea is to hold as many stocks, in as many industries, and in as many countries as reasonably possible. Stock and bond index funds broaden market coverage and promise optimal exposure to reliable sources of expected return at minimal cost to the portfolio. Transaction expenses, taxes and tracking error, the byproducts of portfolio management, are the unavoidable costs of asset allocation. Passive and index portfolio management offers a superior way to invest because it is designed to reduce the inescapable costs of asset allocation; costs that penalize long-term expected returns.