If you are a frequent reader of DollarsAndSense.sg, you would know that our team are big advocator of passive investing, and not without reason.
Passive investing allows investors to make returns from the stock market without needing to know everything about the stock market. This is in contrast with active investing, where investors need to be knowledgeable to buy the right stocks with the aim of generating higher returns.
While the debate about whether passive investing is better than active investing continues on, one area that many investors don’t talk about is how both active and passive are actually linked to one other.
The recognition of the relationship shared between these two investing approaches can help you better appreciate both strategies, and to also decide which would work best for you personally.
How Efficient Are The Markets?
Before going into the relationship shared between passive and active investing, we first need to understand the concept of the “Efficient Market Hypothesis (EMH)”.
The EMH theory states that stock markets are efficient and that current stock price reflects all relevant information. The general idea is that because stocks are fairly priced, investors cannot make higher than market returns from the stock market.
This is an important theory because your views on it ultimately determine your investment strategy. Let us explain why.
Also known as the random walk theory, weak-form efficiency states that future price of a stock cannot be predicted by looking at past prices, and that any price patterns that is observed through technical analysis is useless, since price follows a random walk theory.
However, weak-form efficiency accepts the possibility that fundamental analysis (i.e. the process of evaluating a stock to determine it’s true value) can lead to the identification of undervalued stocks. Hence, those who believe that markets are in a weak-form efficiency could try to earn higher returns by chossing the right stocks to invest in.
Semi-Strong And Strong-Form Efficiency
Both the semi-strong and strong-form efficiency share a similar belief, which is that neither technical nor fundamental analysis would allow investors to earn a higher return from the market. The hypothesis backing this belief is that stock markets are already fairly priced, with all available information pertaining to a stock already taken into consideration by market participants and reflected in the current stock price.
The strong-form efficiency goes one step further in presuming that current stock price also takes into account any information not publicly known. In other words, it assumes that even company’s insiders who trade stocks based on confidential information would not be able to make a higher return from the market.
For investors who subscribe to the belief that markets are either semi-strong or strong form, a passive investment strategy makes the most sense, since the aim is to try achieve the market returns with as little transactional cost as possible, rather than to try beat the market through active investing.
How Information Affects The Efficiency Of The Market?
For markets to be efficient, whether in weak-form, semi-strong or strong-form, information needs to be available to market participants. Remove some information from the equation and market participants would no longer be able to evaluate stocks accurately.
A simple analogy would be traditional and e-commerce shopping. If you were to buy electronics gadget before the day of the internet, it might have been possible that you pay more for a product that sells at a cheaper price elsewhere in Singapore. This happens because information pertaining to the price of the product is not readily available.
However with e-commerce shopping today, it’s a lot harder for shops to get away with overcharging their customers. This is because people have quick access to obtain the information they need about how much a product costs.
The same logic applies to stocks. Give market participants more information and they are more likely to be accurate in assessing the fair price of a product, thus ensuring an efficient market.
How Passive Investors Free Ride On Active Investors?
Active investors search for opportunities where they are able to successfully earn higher returns by identifying undervalued stocks that not everyone knows about. This is applicable in the case of a weak-form efficiency market.
As enough active investors start entering a particular financial market to search for investment opportunities, the market slowly (but surely) starts evolving into a semi-strong efficient market. That is where stocks start being fairly priced, thanks to the accurate analysis provided by active investors, which ironically means that it becomes harder for active investing to generate superior returns.
Passive Investors Rely On Active Investors To Keep Market Efficient
Passive investors believe that trying to find investment opportunities to get a higher return from the market is pointless since markets are already efficient. At the same time, they must not forget that the market is only efficient because of the analysis and actions taken by the active investors themselves.
If more active investors become passive investors, the opportunity to gain a higher return via active investing increases, thus giving higher returns to good active investors, and attracting more investors to switch back from a passive approach to an active approach.
At the end of the day, both active and passive investors share a common goal, and that is to generate returns from their investments. At the same time, they keep each other in check via the different approaches they take.
Whether you see yourself as an active or passive investor, or someone who is in between the two schools of thoughts, it’s worth remembering that both these strategies could work depending on the market you are in, and your investment objectives and existing knowledge. Choose the approach that best fits you.
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