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Passive Investing |
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What is Passive Investing?
Passive investing makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive investing invests in broad sectors of the markets, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce. Passive investing makes little or no use of the information active investing seeks out. Instead, passive investing allocates assets based upon empirical research delineating probable asset class risks and returns, diversifying widely within and across asset classes, and maintaining allocations long-term through periodic rebalancing of asset classes. Which works best, passive investing or active investing? Research supporting passive investing comes from universities and privately funded research centers, not from Wall Street firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in the huge profits available from active management. The results from this research are very clear: Active investing is an appealing mirage which substantially boosts costs and decreases returns compared to passive investing. Research employed in the development of passive and index investment strategy has shown this. Passive investing outperforms active investing. Because of increased costs and risks, about 75% of active managers, as a group, underperform passive investing strategies during any given year and, over time, this percentage increases until only a few outperform market averages. When matched for asset type and mix, passive investing outperform active managers by about 2% per year, on average. In addition, active management in taxable accounts creates a constant stream of capital gains taxes which must be paid each year. Studies show that after-tax returns in active accounts are 30% lower, or more, over long investment time-frames. "Smart money" uses passive investing An estimated 40% to 50% of all institutional assets are in index or passive investing portfolios while only 3% to 4% of retail investors make use of passive investing strategies. Passive investing strategies are employed by AT&T, CALPERS, IBM, Intel, K-Mart, PacTel, Pepsi, and Stanford University, among many others. Opportunity cost of distraction One of the best and least used arguments in favor of passive investing is opportunity cost. Imagine how much time and energy is used up in worrying about and tracking individual stocks or mutual funds. That time and energy is an opportunity cost. For if one devoted that amount of time and energy to a career or to starting one's own business, one could probably become much wealthier. So the way to manage investments with the least amount of opportunity cost of distraction would be passive investing. We think for most investors the arguments are overwelming. Passive investing is the way to go. |
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