The Power of Passive Investing

1. Passive investing outperforms active management over the long term

The evidence powerfully confirms that, at least in the mutual fund industry, the holy grail doesn't exist.

Overwhelming evidence. Decades of academic research and real-world performance data demonstrate that passively managed index funds consistently outperform actively managed funds over long periods. This is primarily due to lower costs and broader diversification. Studies show that only about one-third of active funds beat their benchmarks in any given year, and this percentage decreases over longer time horizons.

Simple arithmetic. The aggregate return of all investors must equal the market return minus costs. Since passive funds have lower costs than active funds, they mathematically must outperform the average active fund over time. This "zero-sum game" concept, articulated by Nobel laureate William Sharpe, forms the foundation of the case for passive investing.

2. Index funds offer superior diversification and lower costs

Wasting beneficiaries' money is imprudent. In devising and implementing strategies for the investment and management of trust assets, trustees are obliged to minimize costs.

Broad market exposure. Index funds provide investors with exposure to entire market segments or asset classes, eliminating the risk of underperforming due to poor stock selection. This broad diversification reduces unsystematic risk without sacrificing returns.

Cost advantage. The expense ratios of index funds are typically a fraction of those charged by actively managed funds. This cost difference compounds significantly over time, leading to substantial outperformance. Additionally, index funds have lower turnover, resulting in greater tax efficiency for taxable investors.

• Average expense ratio for active equity funds: 1.0% - 1.5%
• Average expense ratio for index equity funds: 0.1% - 0.3%

3. The odds of selecting winning active funds are low and diminish over time

Past performance is not an indication of future returns.

Persistence of performance. Studies consistently show that past outperformance does not reliably predict future success. Even funds with strong track records often fail to maintain their edge, making it extremely difficult for investors to identify future winners.

Compounding probabilities. The likelihood of selecting multiple outperforming funds and maintaining that selection over time is vanishingly small. For example:

• Probability of selecting a single outperforming fund over 1 year: ~33%
• Probability of selecting 5 outperforming funds over 5 years: ~1%
• Probability of selecting 10 outperforming funds over 10 years: <0.1%

4. Asset allocation is more important than individual security selection

At the 50,000-foot level, asset allocation is all about developing overall return goals while controlling risk.

Primary driver of returns. Research indicates that asset allocation decisions account for the vast majority (often cited as 90% or more) of a portfolio's long-term performance variability. This far outweighs the impact of security selection or market timing.

Risk management. Proper asset allocation allows investors to tailor their portfolio's risk level to their specific goals and risk tolerance. It provides a systematic approach to diversification across different asset classes, reducing overall portfolio volatility.

Key asset allocation considerations:

• Time horizon
• Risk tolerance
• Investment goals
• Correlation between asset classes

5. Market timing and tactical asset allocation rarely succeed

Investors require unusual self-confidence to ignore the widely hyped non-core investments and to embrace the quietly effective core investments.

Difficulty of prediction. Consistently predicting short-term market movements is virtually impossible, even for professional investors. Studies show that most attempts at market timing result in underperformance compared to a buy-and-hold strategy.

Behavioral pitfalls. Market timing often leads investors to buy high and sell low, driven by emotions rather than rational analysis. This tendency is exacerbated during periods of market volatility.

Common market timing mistakes:

• Overreacting to short-term news
• Chasing past performance
• Failing to rebalance systematically
• Underestimating the impact of trading costs and taxes

6. Passive investing aligns with fiduciary duty for trustees and advisors

Low-cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions.

Prudent investor rule. Fiduciaries are legally obligated to act in the best interests of their clients or beneficiaries. Passive investing, with its focus on low costs, broad diversification, and evidence-based approach, aligns closely with these fiduciary responsibilities.

Risk management. By eliminating manager risk and reducing costs, passive strategies help fiduciaries fulfill their duty to minimize unnecessary risks and expenses. This approach is particularly relevant for trustees overseeing pension funds, endowments, and other long-term institutional portfolios.

7. A disciplined, low-cost approach is key to long-term investment success

Investing for the rest of your life and the lives of your loved ones is serious business.

Consistency is crucial. Maintaining a disciplined investment approach, regardless of short-term market fluctuations, is essential for long-term success. This involves sticking to a well-defined asset allocation and regularly rebalancing the portfolio.

Compounding of costs. Even small differences in fees can have a substantial impact on long-term returns due to the power of compounding. By minimizing costs through passive investing, investors can significantly improve their odds of reaching their financial goals.

Impact of fees on a $100,000 investment over 30 years (assuming 7% annual return):

• 0.1% annual fee: Final value = $741,344
• 1.0% annual fee: Final value = $574,349
• Difference: $166,995 (22.5% less wealth)

8. Behavioral biases often lead investors astray from rational decision-making

We tend to feel brave when prices are going up, which means that it's not the ideal time to decide our risk tolerance level.

Common cognitive errors. Numerous psychological biases affect investment decisions, including:

• Overconfidence
• Loss aversion
• Recency bias
• Confirmation bias
• Herd mentality

Mitigating biases. Passive investing helps investors overcome many of these biases by providing a systematic, rules-based approach to investing. It removes the temptation to make emotional decisions based on short-term market movements or the illusion of skill in security selection.

9. Passive strategies benefit both individual and institutional investors

Trustees who oversee other people's money are under strict legal requirements to act in the best interest of the beneficiaries to which they are responsible.

Applicability across investor types. The benefits of passive investing apply to a wide range of investors, from individuals saving for retirement to large institutional investors managing pension funds or endowments.

Scalability and simplicity. Passive strategies are easily scalable and can be implemented effectively for portfolios of any size. They also simplify the investment process, reducing the need for complex analysis and frequent decision-making.

Benefits for different investor types:

• Individuals: Lower costs, improved diversification, tax efficiency
• Pension funds: Reduced liability risk, improved transparency, lower fees
• Endowments: Consistent long-term performance, easier governance
• Advisors: Scalable business model, alignment with fiduciary duty

10. The investment industry often conflicts with investors' best interests

Wall Street is full of promises.

Misaligned incentives. Many financial institutions profit from complexity and frequent trading, which are often at odds with investors' best interests. This can lead to the promotion of high-cost, actively managed products that are unlikely to outperform over the long term.

Education and transparency. Investors need to be aware of potential conflicts of interest and seek out advisors who prioritize their clients' interests. Passive investing provides a transparent, low-cost alternative that aligns more closely with investors' goals.

Key considerations when evaluating financial advice:

• Fee structure (commission-based vs. fee-only)
• Fiduciary status of the advisor
• Investment philosophy and approach
• Transparency of costs and potential conflicts

Last updated: August 21, 2024