The Old-School Stock Market

In the years before the 2008 financial crisis, index funds existed but active stock pickers were the primary force in the market, since passive funds held a much smaller market share. Active individuals and institutions analyzed companies based on fundamental data like sales, earnings, and cash flows as well as subjective considerations. Using this valuation work, they determined which stocks to buy for client portfolios. Their process would also suggest when to sell.

Based on this fundamental research, active investors bought and sold shares of companies from other informed active investors in the stock market. It may sound very basic but a fundamental truth to remember about the market is that every transaction must have a buyer and a seller. This key point comes into play as we observe the shift in recent years from an active-investor-dominated market to a passive-investor-dominated market.

Changes in stock prices caused investors’ views on a given stock to change. If the price rose sharply, one might decide to sell. If it fell, one might buy more if their view of the company did not change, or they might sell if there was a negative surprise in the firm’s reported earnings, for example.

This is how a market functions normally. Informed participants meet and the forces of supply and demand cause price changes. When buyers feel more urgency to transact than sellers, the stock price rises and vice versa.

But, it’s not how things work now….

Next Page – Active Funds Hemorrhage Cash While Passive Gains