Broker Check

3 to 1 Odds Favor Index Investors

| March 30, 2014

“Equity” (stock-based) investments can be broadly divided into 2 categories.

These two categories could be called “passive” & “active,” or “index” & “other.”

Definition:  If it might be suitable for you to own some type of investment in stocks (aka “equities.”)  For the sake of definitions, let’s just call two types of available stock-based investments

  1. Index
  2. Other

By the way, if we want to be a bit fancy (and obscure,) we could also call the 2 kinds of investments in stocks

  1. Passive
  2. Active

 In a recent article (link is below,) Rick Ferri stated that there are “3 to 1 Odds” that favor index (passive) investors over “other” (“active”) investors.”  That is because, according to Ferri,

“On average, over a five-year period, about 25% of actively managed” (investments) “will outperform their benchmark, 25% of” actively managed (investments) “will underperform by a small amount, 25% will underperform by a large amount, and 25% won’t make it the entire five years.  3-to-1 odds favoring index  . . . . investing has showed up consistently over the decades and it has shown up again recently.”


Ferri’s last point above is obscure but important.  Index investments have been around for some time, especially the larger and more popular indices.  It would not be true to say an index investment never “goes away,” but in general, that would be rare.

Not so with active investment vehicles.  They go away all the time, and or get folded into or absorbed by other investment vehicles.  Therefore,survivorship bias means that, over time, a larger and larger proportion of the poorly performing active investment vehicles go away.  So the comparison between active and passive isn’t really a fair one.  Passive really doesn’t change much, while the active group continues to winnow down.

The above is a very interesting point.  “Active” investments are very frequently marketed and / or sold on the basis of performance.  While those who recommend passive investment much more often take the position that it makes more sense to “be the market, not try to beat the market.”

Yet Ferri’s point and the research he points to (as well as lots of other research, including that done by Nobel Prize winners) shows the potential superior performance of passive, even though passive investments are often recommended for other reasons than pure performance.

Missing from Ferri’s discussion is the likelihood that the underlying cost & expense structure of passive investments could be lower than active investments – a topic for a separate post.

 Ferri concludes by stating:

“It’s my belief and the belief of other advisers who are passionate about index investing that holding a diversified portfolio of all index (investment vehicles) increases an investor’s probability for reaching their financial objectives”

 Now that’s the bottom line . . . . reaching your goals!

Related Links