Active vs. Passive investing. Image by Zynatis/shutterstock.

Today’s stock market is a dynamic and scary place.

Once upon a time choosing stocks to invest in based on the fundamental value of the companies they represent (called fundamental or value investing) was the dominant paradigm for investors. No longer.

In 2017, JP Morgan estimated that only 10 percent of trading came from fundamental investors. The vast majority of trading now comes from computer based algorithmic trading, and passive investors following pre-defined rules, such as index investors. According to Morningstar, nearly 45 percent of all stocks are owned by passive investors. These should be combined with “near passive” strategies, like over a third of “active” mutual funds which track their benchmarks so closely that no matter how skilled, they will not be able to beat the benchmark by enough to justify their fees.

The very prevalence of passive investors owes its rise to the belief that a fundamental investor’s task is ultimately futile.The popularity of passive investing grows along with the belief that the rewards of active investing do not justify the costs of the diligent investment research required to do it well.

This is a self-undermining prophecy. Active investing preserves the health of the stock market, ensuring that stocks trade near their fundamental values because fundamental investors sell stocks that become overvalued (lowering the price) and buy stocks which become undervalued (raising the price). In the absence of fundamental investors, stock prices cease to reflect their fundamental values, which in turn increases the rewards to skilled fundamental investors.

As most investors abandon any attempt to beat the market, the potential rewards the courageous few who remain can only grow. But potential profits will not become actual gains without investing skill.

A farmer in a modern tractor mowing an endless field. Image by RikoBest/Shutterstock.

I see strong parallels between the recent move towards passive investing and the transition of small scale farming to modern agriculture. Modern, mechanized farming is a success in its ability to produce tremendous amounts of food with very little labor, benefiting consumers with incredibly low priced food.

Unfortunately, the benefits of mechanized farming come with many hidden costs, most of which are not immediately felt by either the farmers or consumers. Monocultures leave farms more vulnerable to pests, and reduce biodiversity which supports native pollinators. Eschewing natural pest control requires the increased use of pesticides which often contaminate the environment and even the food produced, while killing beneficial organisms in the soil. Degraded soil requires increased fertilizer use, which further degrades the soil and contaminates the environment.