Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

by William Poundstone

Sharpe offered a counterargument. Divide the world into “active” investors and “passive” investors, Sharpe said. A passive investor is defined as anyone sensible enough to realize you can’t beat the market. The passive investor puts all his money into a market portfolio of every stock in existence (roughly, an “index fund”). An active investor is anyone who suffers from the delusion that he can beat the market. The active investor puts his money into anything except a market portfolio. By Sharpe’s terminology, an active investor need not trade “actively.” A retired teacher who has two shares of AT&T in the bottom of her dresser drawer counts as an active investor. She is operating on the assumption that AT&T is a better stock to own than a total market index fund. Active investors include anyone who tries to pick “good” stocks and shun “bad” ones, or who hires someone else to do that by putting money in an actively managed mutual fund or investment partnership. Who does better, Sharpe asked: the active investors or the passive investors? Collectively, the world’s investors own 100 percent of all the world’s stock. (Nothing is owned by extraterrestrials!) That means that the average return of all the world’s investors—before you factor in management expenses, brokerage fees, and taxes—has to be identical to the average return of the stock market as a whole. It can’t be otherwise. Even more clearly, the average return of just the passive investors is equal to the average sto...

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