All we need is…. Arithmetic?

One of the seminal articles in academic finance was published in 1991. It was published in The  Financial Analysts' Journal. The author was none other than William F. Sharpe, the winner of 1990 Nobel Memorial Prize in Economic Sciences and the creator of the “Sharpe Ratio” which measures the excess return per unit of risk.

It is very short article and I encourage anyone interested in reading it in its entirety. For others who are time challenged, or don’t want to go through the entire piece, here is a statement that summarizes the article succinctly:

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

He goes on to prove (in only 3 pages) through simple arithmetic and logic that only a minority of active managers outperform the index. As a group, active managers have to underperform passive managers, because the costs of active management is higher – research costs, salaries for analysts etc. Sure, there will be some managers who will beat the passive index-based investors, but it is highly unlikely that it based on skill.

There is mountain of evidence that the best course for majority of investors is to invest in a globally diversified portfolio of equity and fixed income assets based on their need, ability and willingness to take risk. Any other strategy is likely to be sub-optimal.

Interested to know more? Feel free to schedule a no-obligation consultation with me today!

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