Personal Finance – Passive Investing Turns 40-ish

Index Funds turn 40 Personal Finance - Passive Investing Turns 40-ish
SAGE Advisory Group:
Passive Investing – a reason to party.

With no birth certificate on file, the precise day remains fuzzy. But if you’re looking for a reason to party (and who isn’t?) let’s call September 4, 1974, the day that passive investing was born. Whether it’s actually a bit older or holding strong at 39, now is as good a time as any to celebrate the profound influence passive investing has had for countless investors through the years and around the globe. And, in many ways, it’s only just now hitting its prime.

Before There Was Passive Investing
Before index funds (which we’ll turn to in a moment), there was no debate about “active versus passive” investment strategies. There were only active investors, all of whom sought to enrich themselves by being better than others at consistently identifying mispriced securities that they could buy at a bargain and sell at a profit.

The only problem was, it’s illogical to expect to consistently identify mispriced securities. University of Chicago Professor Eugene Fama showed us this in the 1960s, when he established the Efficient Market Hypothesis (EMH). EMH demonstrates that a stock’s current price is the best, collective estimate of its fair price. The implications are striking:

  1. Attempting to beat pricing set by the market – i.e., outfoxing the market at its own game – is expected to be an exercise in frustration, especially after factoring in the costs involved.
  2. Instead, the best way to capture market returns is to invest in broad market classes (“asset classes”), according to your personal goals and risk tolerances … and hang on for the efficient, low-cost ride.

The Birth of Index Funds
Princeton University Professor Emeritus Burton Malkiel introduced efficient market concepts to the general public in his 1973 seminal work, “A Random Walk Down Wall Street.” Then, on September 4, 1974 (just over 40 years ago), Rex Sinquefield and colleagues at the American National Bank Chicago incorporated these same, early academic insights into a practical, investable solution when they launched the Standard and Poor’s Composite Index Funds.

Sinquefield went on to co-found Dimensional Fund Advisors. Now retired from Dimensional, he commemorated the 40th anniversary of his first index fund with a September 5, 2013 guest column in Forbes, in which he wrote, “Hearing for the first time the idea that stocks always trade at their fair value was like a lightning bolt going off in my mind. It was a simple and seemingly irrefutable idea whose time had come. I knew it had to be true.”

Good, Better, Best
What is an index fund, anyway? Indexes measure available returns from particular asset classes by following a representative sampling from them. Thus, the well-known S&P 500 Index tracks 500 representative U.S. large-company stocks. By setting up a fund that contains those same stocks, the fund can efficiently and relatively cost-effectively deliver the same returns that particular asset class delivers.

That’s good. But when they were launched, the American National Bank Chicago fund and a similar offering from Wells Fargo were only available to institutional investors. In 1975, when John Bogle launched the predecessor of the now-familiar Vanguard 500 Index Fund, the concept was still being derided as “un-American” and “Bogle’s folly.”

So, while these early index funds were groundbreaking, there was room for passive investing to improve. And improve it did. Malkiel’s “Random Walk” book is now in its 10th edition and still selling strong. And in mid-October, Professor Fama was at long last awarded the 2013 Nobel Prize in Economics, for his 1966 empirical analysis of securities pricing in efficient markets.

Speaking of Professor Fama, who sits on the Dimensional board, “passive” fund management also has come a long way. Building on the original concept of rigidly tracking indexes, we now have solutions available that more fluidly and directly track the asset classes we’re really trying to efficiently capture.

That’s where Dimensional’s unique strategies come into best play… the subject of our next blog post.

In the meantime, happy birthday to passive investing, and warmest congratulations to Professor Fama for his richly deserved Nobel prize!

SAGE Serendipity: It’s not every Nobel laureate who describes his early work as akin to “shooting fish in a barrel.” We’ve seen the math, and we know better! Enjoy Professor Fama’s other comments about his career in this three-minute video.

Sheri Iannetta Cupo, CFP®, is Founding Principal of SAGE Advisory Group, based in Morristown, NJ, an independent, Fee-Only Registered Investment Advisory firm, specializing in providing busy professionals and their families with holistic financial life planning and investment management services. You can find more here: where this post originally appeared. You can also connect with Sheri on Twitter, Google+ and LinkedIn.

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