Investigating passive and active investing, the authors analyze misconceptions about each and find that both play critical roles in markets. In different yet complementary ways, they drive markets toward efficiency and enhance capital allocation.
Overview
This brief argues that active and passive investing both have a role in financial markets, contributing to overall market growth and stability. It also corrects some misconceptions about the meaning of active and passive investing.
The authors discuss the parallels between entrepreneurship in the economy and active investing in financial markets. They emphasize that just as entrepreneurs drive progress and innovation by creating new products or services, active investors play a similar role in finance by making decisions that allocate capital, guided by their insights into market opportunities.
The authors differentiate between two types of entrepreneurship: Schumpeterian, which involves introducing entirely new innovations and creating demand, and Kirznerian, which focuses on discovering and exploiting market inefficiencies. They make the case that Kirznerian is the most important form of entrepreneurship and also the one investors need to understand, because it parallels the entrepreneurship practiced by active investors.
In financial markets, active investors can be seen as entrepreneurs who take on risks by making informed decisions that have the potential to yield above-average returns. These investors, similar to entrepreneurs, operate on various time horizons, with some focusing on short-term opportunities and others taking a longer-term approach.
This brief also highlights the concept of passive investing, wherein investors follow broader market trends without actively seeking to exploit market inefficiencies. It argues that no investor can be entirely passive, given that all investment decisions involve some level of active choice, such as selecting which markets or indices to invest in. The discussion also extends to the importance of human capital as a component of wealth and the challenges of integrating it into financial markets.