The growth of passive investing has been a huge boon to everyday investors since it began in the 1970s. The main idea of passive investing: Since it is very difficult to consistently outsmart the collective wisdom of the market, then it pays to “trust” market prices and spend less time/energy/money on identifying under or over priced securities. By and large, most of the research shows that passive investors benefit by taking this approach. However, there are limits to passive investing.
Specificially, when a passive investor buys new stocks he or she generally invests the money into a pre-determined basket of securities (ie perhaps the S&P 500). Many of these indexes are market cap weighted…meaning, the biggest stocks comprise a larger share of the index. When a passive investor buys a market cap weighted index, they are investing a greater share of their money into stocks that already are the largest stocks. The strategy assumes that the biggest companies in America are trading for reasonable and fair prices and that they are worthy investments. This process creates demand for these largest stocks which in turn could be propping up the value of those same mega cap stocks.
Fortunately, there are other ways to invest. Our strategy takes some of the best parts of passive investing, while we also consider the value of our investments. Are we buying stocks with high relative prices or are we emphasizing stocks with lower relative prices? If everyone else has bid up the price of a popular stock, do we really want to buy that stock without regard for its future cash flows?
Passive investors are an important part of the overall market. I would argue that they can influence the market, but they do not break the market. Eventually, companies with the best cash flows will be rewarded with higher stock prices. Investors with a value approach can be rewarded for being patient and not overpaying for stocks without regard to price.
For Verisail clients, feel free to reach out to us if you have questions about your portfolio or our strategy for you.