Passive vs Active Investing
This is a great topic that I think needs to be discussed for sure.
In 2006 at MIT, the finance and economics gospel was always passive investing. The market is all mighty, all efficient, you can never beat it, etc. Just buy the S&P 500 and do nothing, and if you are an active trader you are doomed.
The efficient market professors who all won Nobel Prizes often treated this as such absolute dogma that it just drove me nuts.
As usual, the truth is somewhere in the middle!
In the end, who is counting the cars at Walmart during Christmas, to estimate demand for the 4th quarter? Who is figuring out whether the books are cooked (e.g. Enron, etc.)? Those active investors are the ones making the prices of stocks efficient, and they get paid when they discover an inefficiency. To think that the markets just magically make perfect prices with no human active trading is just lunacy.
Here, I want to take a quick second as to why active trading is important. I often compare and contrast stock trading and gambling — sometimes they have more similarities than people like, and sometimes they are fundamentally different.
When you bet on a roulette wheel, you are not affecting the outcome. Whether you put 25 dollars on 13 red, or 2500 dollars, the spin’s outcome will be the same.
“Active” trading a stock is not the same as gambling, for a very important reason. When you “bet” on a stock you are pushing the price up, and this has lots and lots of reinforcing effects that do affect the outcome for the company. I’ll mention just a few.
Employees are happier! (if they have stock) Their motivation increases, and morale is boosted. These companies get to poach the creme de la creme from top engineering schools who see a higher stock price as a proxy for being part of a winning company.
The “bet” (someone actively buying) has improved the company’s fortunes. And of course, they can issue more secondary securities in a less diluted fashion to further their ambitions. TSLA is a fantastic example of this dynamic (much easier to build more Gigafactories when you’re valued at a trillion dollars than a billion).
Also, suppliers look at the increased share price (and market capitalization value) and believe you are more stable. They will extend you more generous terms to supply the inputs for your business. This can be better credit, more allocation of sales people to your account, higher discounts vs your competitors, etc.
Actively buying a stock affects the perception of a company’s fortunes when the price goes up, and then the perception reinforces and improves the reality of the company. Back to the gambling analogy: it’s like if you had a roulette table, and the more you bet on a number, the more likely the number would come up.
So active investment is important, but unfortunately too much of this can go the wrong direction as well, and the efficient market professors are not entirely wrong. The market is incredibly efficient, and is incredibly hard to beat. If it were easy, everyone would be a billionaire by now. But it’s the professionals who do that, not retail customers. So that is what led to the blanket recommendation to just passively invest.
During the pandemic, when I had friends ask me to teach them to trade stocks, I didn’t even know what to make of that question or how to answer it. And unfortunately, I’ve seen a lot of situations where my friends take this to extremis — nobody wants to do “regular” work anymore. They are constantly on Robinhood and owning and day trading a handful of stocks in their pajamas. This is too far on this side of the equation.
So there needs to be a balanced mix of passive investors (just buy a diversified, capitalization weighted basket of securities), and people who do it 100% professionally with their time, counting cars at Walmart, examining satellite photos to see how grain supplies are looking, etc.
And finally, people who do a bit of both! Go buy TSLA if you like the product, as Elon is suggesting in his tweet. This is a good way for some people to “vote” for things they happen to like, and indirectly help the company as well. But don’t spend your entire day, day trading TSLA. And keep the rest in some passive investments that professionals are pricing reasonably fairly on a day to day basis.
This is really the key end state for a healthy and vibrant capital markets situation for society, in my view. Have some segment of the population devoting their careers to trading and valuing financial assets, and have the other segment do some passive stuff with a bit of “voting with their wallets” on stocks they happen to like and therefore support the company they are investing in.
But if you’re in the second category, try try not to spend 24/7 on it — it becomes more gambling at that point, with the house edge being commission on every trade. They add up! But Wall Street takes advantage of the fact that the volatility of your PnL will obscure the small but inevitable accretion of the fees you are incurring per trade. This applies to crypto “investing” as well.
(This should not be construed as investment advice, because, what the hell do I know…)