Thursday, August 07, 2014

Active Investing: The Happiness Quotient

On average, passive investing produces better returns than active investing. In a rational world, shouldn't active investors become extinct?

No. The economic benefits of active investing aren't limited to the net returns after fees, trading costs and taxes. While passive investing is as exciting as watching grass grow, picking stocks is interesting, challenging and sometimes even fun.

Thus, the benefits of active investing include the net return plus a happiness quotient.

A happiness quotient? The economic concept emerges in a cost-benefit analysis of smoking tobacco. Smoking's costs include increased risk of lung cancer and a shortened life expectancy. However, the estimated happiness benefit – the pleasure of smoking – offsets an estimated 70 percent of the cost. (Critics argue that the percentage is too high.)

In the context of investing, the economic value of the happiness quotient should be easier to compute. If hedge-fund investors settle for  an average return of 9 percent during a period when the S&P is returning 12 percent, the economic value of their happiness quotient must be at least 3 percent.

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