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PAGE ONE Economics

®

Stock Market Strategies: Are You
an Active or Passive Investor?
Scott A. Wolla, Ph.D., Senior Economic Education Specialist

GLOSSARY
Bonds: Certificates of indebtedness issued by
a government or a publicly held corporation, promising to repay borrowed money
to the lenders at a fixed rate of interest
and at a specified time.
Capital gains: A profit from the sale of financial investments.
Diversification: Investment in various financial instruments in order to reduce risk.
Dividend: A share of a company’s net profits
paid to stockholders.
Efficient market hypothesis (EMH): The
theory that the current price of a stock in
a corporation reflects all relevant information about the stock’s current and future
earnings prospects.
Index fund: A mutual fund with the objective to match the composite investment
performance of a large group of stocks or
bonds such as those represented by the
Standard and Poor’s 500 index.

“October. This is one of the peculiarly dangerous months to speculate in
stocks. The others are July, January, September, April, November, May, March,
June, December, August, and February.”

—Mark Twain, Pudd’nhead Wilson

If you ever ask an economist which stocks to buy, chances are you won’t
get a specific answer. Instead, you might hear about the “efficiencies” of
markets.1 In fact, there’s an old economics joke about market efficiency:
Two economists walk down a sidewalk—one is older and wiser and the
other is younger and less experienced. The younger economist says, “Look
a $20 bill” and bends down to snatch it. The older economist says, “Don’t
bother! It can’t be real or someone would have already picked it up.”
The joke is meant to exaggerate the belief held by many economists that
markets quickly adjust to new information. Financial markets are said to be
“efficient” if they leave no “money on the table” for very long. If there’s an
opportunity to make a profit, buyers and sellers will swoop in and take it.
Hence the joke—a $20 bill left on the street for any length of time might
not be a real $20 bill at all.

Portfolio: A list or collection of financial assets
that an individual or company holds.
Stock market index: A collection of stocks
chosen to represent a particular part of
the market.
Stock mutual fund: A mutual fund that buys
stocks in order to make profits for the
investors.
Transaction costs: The costs associated with
buying or selling a good, service, or financial asset.
Volatile: Likely to change in a sudden or
extreme way.

Making Money in the Stock Market
Savers have many investment options to choose from. Investing in stocks
has risks, but over time, the stock market tends to have higher average
returns than other popular investment options (see the boxed insert “Stock
Market Returns Over Time”). Investors earn money on their stock purchases
through dividends and capital gains. Dividends are shares of a company’s
net profits paid to stockholders. Dividends are often paid quarterly and
are commonly associated with established, profitable companies. Capital
gains are the profit from the sale of a financial investment—for example,
when a stock is sold for more than the original purchase price.
Every investor hopes to earn high returns—dividends plus capital gains—
while minimizing risk. An effective way to minimize the risk of investing
in stocks (a relatively risky financial asset) is to diversify. Diversification
means to invest in various financial instruments—not just a specific one.

April 2016

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Stock Market Returns Over Time
Historically, average returns for stocks (as indicated by the S&P 500) have been higher than for other investment options, such as government bonds (e.g., 3-month Treasury bills [T-Bills] and 10-year Treasury bonds [T-Bonds]).

Years

S&P 500

3-Month T-bills

10-Year T-bonds

Since 1928

1928-2015

9.50%

3.45%

4.96%

Last 50 years

1966-2015

9.61%

4.92%

6.71%

Last 10 years

2006-2015

7.25%

1.14%

4.71%

NOTE: Data are geometric averages.
SOURCE: Damodaran, Aswath. “Annual Returns on Stock, T.Bonds, and T.Bills: 1928–Current.” New York University Stern School of Business, January 5, 2016;
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html. FRED® (Federal Reserve Economic Data), Federal Reserve Bank of St. Louis.

So a diversified stock portfolio could include stock purchases across industries, company size, and even geography. Diversification reduces risk because it is unlikely
that all the stocks in a portfolio will react the same way
to market events. For example, if you invest all of your
money in the stock of a single company that owns several
beach resorts along the Gulf of Mexico, a severe hurricane
could devastate your portfolio. In other words, don’t put
all your eggs in one basket.
One financial instrument designed to provide investors
with diversification is a mutual fund. A stock mutual
fund is an investment product that pools the money of
many investors to purchase a variety of stocks to make a
profit for the investors. Most investors simply don’t have
the time or money to create and manage such a fund
on their own, so mutual funds offer a cost-effective way
to diversify. A variety of stock mutual funds are available
based on different investment strategies (e.g., growth
funds or value funds—see the boxed insert “Stock Fund
Investment Strategies”) and management strategies
(active or passive).

Investment Management Strategies: Active and Passive
The active management investment strategy relies on a
staff of highly paid analysts to build a portfolio of stocks.
The goal is to earn high returns that “beat” (outperform)
the stock market.2 Such analysts use research, forecasts,
and judgment to recommend whether to buy, hold, or

Stock Fund Investment Strategies
Growth fund managers focus on investing in companies expected
to have faster-than-average growth—and higher-than-average
returns. These companies tend to be riskier than average.
Value fund managers focus on investing in companies with stock
prices that suggest they are undervalued. These companies tend
to be mature companies that pay dividends and are less volatile
than companies selected for growth funds.

sell the given stocks. Analysts are always on the lookout
for the best values or companies with strong growth
prospects. Active investing relies on differentiating
between a stock’s value and the market price. Warren
Buffett—often called the most successful investor in the
world—says, “price is what you pay; value is what you
get.” A stock’s value is based on projected future earnings and growth prospects for the company. If a stock is
determined to be undervalued—that is, believed to have
a greater value than indicated by its market price—
managers will buy it for their mutual fund. When the
stock price rises above its value, they will sell it and earn
capital gains for investors. Fund managers might also
sell stocks in the portfolio that are predicted to underperform the market. This buying and selling accrues
transaction costs (which reduce net gains). The most
successful mutual funds are those that consistently outperform average stock market returns.

The passive management investment strategy is based
on the efficient market hypothesis (EMH), which states
that a stock’s current price reflects all relevant information about its current and future earnings. How is this
possible? Stock prices change when information about
the company (or the economy) changes. Imagine you
hear the reporter on your favorite stock market news
channel announce Chatport Technologies3 has just
received a patent on a revolutionary new product. You
consider buying Chatport stock because you predict the
new product will reap huge profits for the company and
its shareholders. Just as the reporter says the words
“received a patent,” the graph on the screen shows the
stock price has increased 10 percent. As it turns out, you
were not the only investor who, upon hearing the news
about Chatport, decided the stock was undervalued and
is willing to pay a higher price for the company’s stock.
When news indicates a stock is undervalued, market participants respond by buying the stock, bidding its price
up to its fair value. When new information indicates a
stock is overvalued, investors quickly sell, putting downward pressure on the stock price, moving it back to its fair
value. The EMH says that new information about a stock
is “priced in” almost instantly—raising or lowering its
price. For this reason, the EMH says the market price is
the best reflection of a stock’s value based on current,
available information. And, if prices reflect all available
information, EMH suggests that the best strategy is to
buy and hold a diversified portfolio and to minimize
investment costs.
The passive strategy holds that the stock market is so
efficient that active managers will not consistently beat
the market because they will not be able to consistently
pick undervalued stocks. And the extra research and
transaction costs involved with actively managed mutual
funds (which are passed on to investors) will offset gains.
Although some actively managed mutual funds do outperform the market, data consistently show that a majority of them fail to outperform market averages reported by
various indexes (such as the Dow Jones Industrial Average,
Standard and Poor’s (S&P) 500, and Wilshire 5000).4

Application of EMH: Index Funds
One type of mutual fund that follows a passive management strategy is an index fund. The goal of an index

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NOTE: The S&P 500 has increased 215 percent from its lowest closing
value during the Great Recession (676.53 on March 9, 2009) to its most
recent high (2130.82 on May 21, 2015).
SOURCE: S&P Dow Jones Indices LLC, S&P 500© [SP500]. Retrieved from
FRED® (Federal Reserve Economic Data), Federal Reserve Bank of St. Louis,
February 29, 2016; https://research.stlouisfed.org/fred2/graph/?g=3gAs.

fund is to “replicate the market,” by simply buying the
stocks included in a stock market index, such as the
S&P 500 index. For example, for a given index fund, if
Chatport Technologies were to represent 1 percent of
the value of the S&P 500 index, the index fund manager
would invest 1 percent of the mutual fund’s assets in
Chatport stock.5 The S&P 500 index includes 500 of the
largest publicly held companies in the United States,
which means that mutual funds that replicate the S&P
500 index hold a diversified blend of large company
stocks. An advantage of index funds is generally lower
investment costs: Rather than paying the research and
transaction costs of active management, index fund managers simply buy and hold the stocks on a given index.
Some research estimates that passive investment strategies save U.S. investors around $100 billion annually6—
one of the reasons economists tend to favor index funds
over picking individual stocks.7

Conclusion
Investors who choose to invest in stocks through a mutual
fund have a decision to make. Do they prefer an active
or passive management strategy? Mutual funds that use
an active management strategy rely on the research skills
of analysts to differentiate between a stock’s value and
its market price. Index funds, which use a passive management strategy, rely on the efficiency of the stock

PAGE ONE Economics®
market to price stocks at fair value. Both types of mutual
funds provide investors with diversified portfolios of
stocks. In the end, the choice is up to individual investors:
Do they believe analysts can outperform average stock
market returns by finding value others have missed or
that the stock market is efficient and leaves no money
on the table? n

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From 30 data series then, to 383,0 0 0 series now.
FRED®: Ser ving data geeks for 25 years.

Notes
1 Mankiw, N. Gregory. “What Stocks to Buy? Hey, Mom, Don’t Ask Me.” New York
Times, May 18, 2013; http://www.nytimes.com/2013/05/19/business/for-stockpicking-advice-dont-ask-an-economist.html?_r=0.
2

To “beat” the market means the portfolio earns a higher return than the market
average or another appropriate measure of stock market performance. For example, a mutual fund focused on large U.S. companies will measure their success
by their ability to outperform the S&P 500 index.
3

Chatport Technologies is a fictitious company.

Join the millions of others who use Federal
Reser ve Economic Data (FRED). Get star ted at
https://research.stlouisfed.org /fred2.

4

Soe, Aye M. “SPIVA® U.S. Scorecard.” S&P Dow Jones Indices, McGraw Hill
Financial, Year-End 2014;
http://www.spindices.com/documents/spiva/spiva-us-year-end-2014.pdf.

® F R E D i s a re g i s t e re d t r a d e m a r k o f t h e F e d e r a l R e s e r v e B a n k o f S t . L o u i s .

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Index fund managers use different methods to replicate the returns of a particular market index. With the replication method, they buy all the stocks in a particular index in the proportions they exist in that index (as described in the text).
With the sampling method, they buy a representative sample of stocks in a particular index that attempts to reflect that index.

6 Lusardi, Annamaria and Mitchell, Olivia S. “The Economic Importance of Financial

Literacy: Theory and Evidence.” Journal of Economic Literature, 2014, 52(1), pp. 5-44;
http://test.financialbuildingblocks.com/assets/The%20Economic%20Importance
%20of%20Financial%20Literacy.pdf.
7

Chicago Booth, IGM Forum. “Diversification.” November 20, 2013;
http://www.igmchicago.org/igm-economic-experts-panel/pollresults?SurveyID=SV_6QNgG8yRblilY0t.

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