There is a lot of Balkanization between adherents of indexing and active stock picking. I don’t worship in either church — they both have their merits. Let’s take a look at each.
The Strengths of an Indexing Approach
An indexing approach has many strengths. It is tax efficient and low cost. It removes tracking error, or the chance that you will substantially underperform the market. Moreover, it is relatively simple and low maintenance. The primary chore is to rebalance if your target allocations get too far out of whack.
These factors make indexing a great bogey for most people. As Jack Bogle says, this is the only way to guarantee you will get your fair share of the market’s returns. Sensibly, indexing has attracted a growing torrent of money in the last several years.
The Success of Indexing Creates Opportunities for Stock Pickers
Ironically, the success of indexing is a gift to the stock picker, because it paints all stocks with the same broad brush. As Elliot Turner indicates in his post Lucky to Live in This Era of Indexation, this undiscriminating wall of money creates many inefficiencies to be exploited.
The popularity of sector ETFs has been a large part of this dynamic, by treating stocks in an industry as a basket and not differentiating between them.
Pitfalls of an Active Approach
If you go the active route, you open yourself up to tracking error. Higher turnover creates higher trading costs and tax inefficiency.
Don’t neglect the advantage that tax efficiency gives indexing. Some active managers attain impressive returns before taxes, but high turnover causes substantial tax leakage. You can’t eat before-tax returns. So remember to compare the after-tax returns from passive and active strategies.
This suggests a low-turnover active approach on the order of Todd Wenning’s Simple Formula for Investing Success: Investment + good company + right price + patience.
Nothing Works All of the Time
Occasionally, someone will discover an anomaly that can be exploited, such as the low-volatility outperformance propounded by Eric Falkenstein. The problem is, as it is discovered by the masses, a torrent of money gets thrown at the strategy and the outperformance gets arbitraged away, at least until the crowd sells and moves on to the next hot fad. So never fall in love with an investment.
The main thing is don’t be dogmatic — you should remain flexible. The king of flexibility was Peter Lynch, who some called the Chameleon. This was key to his success.
Make Love, Not War
In the end, indexing and active stock picking are not mutually exclusive. They coexist and benefit from the existence of each other. And they can easily be combined in some fashion. It doesn’t have to be either/or.