How Markets Work
Worldwide financial markets historically reward investors for the capital they supply. According to financial theory, freely functioning markets accurately set securities prices so investors receive reasonable rewards for taking long-term risks. While markets have grown more complex and sophisticated, they still offer a simple and powerful way for people to exchange value and improve their well-being. Entrepreneurs and investors meet in the capital markets. People supply capital with an expectation of receiving a reasonable return for its use. Their investment capital fuels economic activity. Businesses compete for this capital by offering higher returns, and investors compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that companies must offer returns in line with their perceived risk. When markets work properly, no investor can expect greater returns without bearing greater risk. These rewards do not come from choosing the right stocks or selecting the best time to enter and exit the market. Rather, investors are rewarded for taking risks that bear compensation.
Traditional active stock and bond managers, the type most advisors recommend, strive to beat the market by trying to predict the future. They may bet on certain asset classes, individual companies, countries or industries, or they may choose to temporarily opt out of the market or a segment of it. As new information arises, buyers and sellers make rapid judgments about how it might affect a company's future earnings and risk. Market forces move stock prices toward an equilibrium that balances the collective opinions of all market participants. When research predictions go wrong, active investors miss important returns by holding the wrong stocks at the wrong time, or by being out of the market entirely when prices surge forward. Decades of independent research demonstrate that trying to outperform the market with active investment approaches is a poor use of resources. Without insider information, markets are simply too efficient and unpredictable for any investor to consistently outperform benchmark indexes.
For passive and index portfolio managers like Cardiff Park Advisors, the burden of creating returns is removed from the research process and returned to the responsibility of the market, which sets prices to compensate investors for the risks they bear. Passive investment management is a smarter strategy because it acknowledges that returns come from risk, and at least some risk is essential for long-term gain, but that not all risks carry a reliable reward.
So, passive managers counsel clients to diversify broadly through index funds taking only risks that bear compensation and avoiding risks that don’t generate expected return. These risks may include holding too few securities, betting on particular countries or industries, following market predictions, or speculating based on rating services. For passive managers, the idea is to hold as many stocks in as many industries and as many countries as reasonably possible. Index funds broaden market coverage and promise optimal exposure to reliable dimensions of expected return at minimal cost to the portfolio. Transaction expenses, taxes and tracking error, the byproducts of portfolio management, are the unavoidable costs of asset allocation. Passive and index portfolio management offer a superior way to invest by reducing these and other costs that penalize long-term expected returns.