The capital allocation line shows the risk-return trade-offs available by mixing risk-free as- sets with the investor’s risky portfolio. Investors can choose the assets included in the risky portfolio using either passive or active strategies. A passive investing strategy is based on the premise that securities are fairly priced and it avoids the costs involved in undertaking security analysis. Such a strategy might at first blush appear to be naive. However, we know that intense competition among professional money managers might indeed force security prices to levels at which further security analysis is unlikely to turn up significant profit opportunities. Passive investment strategies may make sense for many investors.
To avoid the costs of acquiring information on any individual stock or group of stocks, we may follow a “neutral” diversification approach. A natural strategy is to select a diversified portfolio of common stocks that mirrors the corporate sector of the broad economy. This results in a value-weighted portfolio, which, for example, invests a proportion in GM stock that equals the ratio of GM’s market value to the market value of all listed stocks.
Such strategies are called indexing investing. The investor chooses a portfolio with all the stocks in a broad market index such as the Standard & Poor’s 500 index. The rate of return on the portfolio then replicates the return on the index. Indexing investing has become an extremely popular strategy for passive investors. We call the capital allocation line provided by one-month T-bills and a broad index of common stocks the capital market line . That is, a passive strategy based on stocks and bills generates an investment opportunity set that is represented by the capital market line.
Historical Evidence on the Capital Market Line
Can we use past data to help forecast the risk-return trade-off offered by the capital market line? The notion that one can use historical returns to forecast the future seems straightforward but actually is somewhat problematic. On one hand, you wish to use all available data to obtain a large sample. But when using long time series, old data may no longer be representative of future circumstances. Another reason for weeding out subperiods is that some past events simply may be too improbable to be given equal weight with results from other periods. Do the data we have pose this problem?
The most plausible explanation for the variation in sub period returns is based on the observation that the standard deviation of returns is quite large in all sub periods. If we take the76-year standard deviation of 20.3% as representative and assume that returns in one year are nearly uncorrelated with those in other years (the evidence suggests that any correlation across years is small), then the standard deviation of our estimate of the mean return in any of our 19-year sub periods will be 20.3/, which is fairly large. This means that in approximately one out of three cases, a 19-year average will deviate by 4.7% or more from the true mean. Applying this insight to the data tells us that we cannot reject with any confidence the possibility that the true mean is similar in all sub periods! In other words, the “noise” in the data is so large that we simply cannot make reliable inferences from average returns in any sub period. The variation in returns across sub periods may simply reflect statistical variation, and we have to reconcile ourselves to the fact that the market return and the reward-to-variability ratio for passive (as well as active!) strategies is simply very hard to predict.
The instability of average excess return on stocks over the 19-year sub also calls into question the precision of the 76-year average excess return (8.64%) as an estimate of the risk premium on stocks looking into the future. In fact, there has been considerable recent debate among financial economists about the “true” equity risk premium, with an emerging consensus that the historical average is an unrealistically high estimate of the future risk premium. This argument is based on several factors: the use of longer time periods in which equity returns are examined; a broad range of countries rather than just the U.S. in which excess returns are computed (Dimson, Marsh, and Staunton, 2001); direct surveys of financial executives about their expectations for stock market returns (Graham and Harvey, 2001); and inferences from stock market data about investor expectations (Jagannathan, McGrattan, and Scherbina, 2000; Fama and French, 2002). The nearby box discusses some of this evidence.
Costs and Benefits of Passive Investing Strategy
How reasonable is it for an investor to pursue a passive investment strategy? We cannot answer such a question definitively without comparing passive strategy results to the costs and benefits accruing to an active portfolio strategy. Some issues are worth considering, however.
First, the alternative active strategy entails costs. Whether you choose to invest your own valuable time to acquire the information needed to generate an optimal active portfolio of risky assets or whether you delegate the task to a professional who will charge a fee, constructing an active portfolio is more expensive than constructing a passive one. The passive portfolio requires only small commissions on purchases of U.S. T-bills (or zero commissions if you purchase bills directly from the government) and management fees to a mutual fund company that offers a market index fund to the public. An index fund has the lowest operating expenses of all mutual stock funds because it requires minimal effort.
A second argument supporting a passive strategy is the free-rider benefit. If you assume there are many active, knowledgeable investors who quickly bid up prices of undervalued assets and offer down overvalued assets (by selling), you have to conclude that most of the time most assets will be fairly priced. Therefore, a well-diversified portfolio of common stock will be a reasonably fair buy, and the passive strategy may not be inferior to that of the average active investor. To summarize, a passive strategy involves investment in two passive portfolios: virtually risk-free short-term T-bills (or a money market fund) and a fund of common stocks that mimics a broad market index. Recall that the capital allocation line representing such a strategy is called the capital market line. We see that using 1926 to 2001 data, the passive risky portfolio has offered an average excess return of 8.6% with a standard deviation of 20.7%, resulting in a reward-to-variability ratio of 0.42.
