Passive Investing: Bringing order out of chaos
Passive investing has evolved gradually over the last half century. Only recently has it matured to the point where trillions of dollars are invested using the passive approach. Prior to that, investing meant selecting individual securities.
Beginning in the 1950s with Harry Markowitz, academics and practitioners started to outline a different approach. In the 1960s, William Sharpe (Nobel Prize winner with Markowitz in 1990) developed the Capital Asset Pricing Model, and Eugene Fama and later with Ken French developed the Efficient Market Theory.
The efficient market (EMT) theory holds that stocks are always correctly priced since everything that is publicly known about the stock is reflected in its price. The clear implication of the theory is that investors are much better served buying large groups of stocks rather than selecting individual securities. There are numerous readings available, among them this article by Eugene Fama, the principal originator of EMT.
All of this reached practitioners in 1975 with the publication of an influential article by Charles Ellis titled “The Loser’s Game”. As captured by Ellis in the middle of a brutal bear market, the idea was that the stock market had become so dominated by professionals that it was highly efficient.
The way to win was by making the fewest mistakes, controlling costs, being disciplined and properly diversifying. The days of the “Go Go Market” of the 1960s were over for good. Swallowing their pride, and taking these findings to heart, a few brave pioneers began developing index funds.