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Did Ben Graham Understand the Difference Between Active & Passive Investing?

Jason Zweig has a great article in the Journal this week about Ben Graham and indexing. He says that Ben Graham would have supported indexing. And yes, Graham didn’t say that indexing was necessarily bad. In fact, he was rather clear about the distinction:

“In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.”

This is Graham’s explanation of the difference between “active” and “passive” investing. But how applicable is this in today’s world? After all, Graham lived in a different era when stock picking was the norm. Today, the most active shares on the exchanges on any given day are not stocks. They are ETFs.  In fact, much of the most “enterprising” investing revolves around macro analysis, sector analysis and index fund analysis. As I’ve stated before, we’re all active asset pickers now.

This raises an interesting point – does Ben Graham’s distinction between active and passive investing really have any meaning in a world where indexes are now the most actively traded instruments in the world? I would argue no. The active vs passive debate has taken on a whole new meaning in today’s macro world where index funds are now the most actively used instruments. It’s no longer about stock picking vs indexing. It’s now about how efficiently one picks their assets whether they’re stocks, bonds or index funds. We all actively pick assets whether they’re stocks or bonds. But some investors are more cognizant of taxes, fees, diversification and the necessarily active components of portfolio management such as rebalancing and risk management. We no longer live in the world of Graham. So it’s time to update our thinking here and evolve with the new realities of the macro world we live in.

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