When Aiming for Average is Better: Passive Investing

The self-help genre has been consistently preaching about improving ourselves, making a difference and being the best you can be.

A couple of common themes are:

  • You have to put in hard work to gain more
  • Be proactive, do not be passive. The world does not owe you anything
  • You get what you paid for. Pay for value
  • Be a master of your craft. Go deeper, understand the complexities, develop sophisticated work.
  • Take control, do not surrender to fate. You are the captain of your destiny
  • Know what you want, drop everything and focus on pursuing your dreams. Eliminate all distractions

Congratulations if you have already made it in life and are doing everything right.

However, for the rest of us who are still struggling to achieve something and failing to follow every self-improvement advice out there, there is still hope. Keep on trying.

But what if I told you that you might be better off not following those advice when investing in the stock market? Especially if you are an average retail investor who do not have the time nor the expertise to analyse stocks.

Is this too good to be true? Can I really gain more by putting less effort, knowing less, paying less, taking less control and not focusing?

Well, let us explore this wonderful investment strategy called passive investing.

Note: I will be talking a lot about ETFs and index funds. Please refer to this article where I explain about these investment products in detail

What is Passive Investing?

Investment strategies fall into two main camps: Active Investing and Passive Investing.

Active investing often involves the investor or the fund manager selecting stocks to include in a portfolio which he or she thinks is undervalued and has potential to beat the benchmark, usually an index.

Passive investing involves the investor or the fund manager selecting an index fund that attempts to replicate the performance of an index.

A quick comparison between active investing vs passive investing
Note: For simplicity, I will only refer to stocks for investing even though it also applies to all other asset classes.

Beating the market means simply generating higher returns compared to the returns of the market as a whole. This is referred to as alpha

The active investing strategy aims to beat the market while the passive investing strategy just aims to mimic the market returns.

So which strategy is better in the long term?

In an attempt to answer this, the S&P group created the S&P Indices Versus Active scorecard (SPIVA) to track the performances of all the active funds relative to their indices benchmarks.

The report is not flattering to active management – in a 5 year period, 78.52% of active funds underperformed the S&P index.

So why is it?

Higher Cost, Better Returns?

If you pay peanuts, you get monkeys.

It makes sense, doesn’t it? You need to pay more to get better returns.

However, it turns out fees have an important impact on investment returns.

Studies had shown that the cheapest funds outperformed the most expensive funds over 5, 10-, 20- periods.

Paying more in fees does not guarantee better returns.

Fees Compound Over Time

Fees, just like interests, compound over time – it grows exponentially eating your returns.

You will see the difference especially over a long period of time.

It is challenging enough to beat the market consistently let alone beating it by a bigger margin to offset the high fees.

Active managers are faced with that challenge. Some that do beat the market but after deducting the fees end up losing the market.

Implementation Costs: Active vs Passive

Actively managed funds hire professional fund managers, analysts, research teams to pick the best stocks and trade at the right timing.

In addition to that, the fund managers perform much more trades compared to passively managed funds. All these factors inflate the costs of actively managed funds.

Passive funds on the other hand do not require a research team.

The fund manager also makes less decisions in what to buy or when to trade – they follow the index and trade when the index changes to mimic it as closely as possible. So, the fees can be much lower.

Due to lower implementation costs, index funds typically cost a fraction compared to active funds.

There is a caveat:

Lowest cost does not necessary mean the best when it comes to selecting funds. The point I am making here is mainly the costs difference in between active and passive investment strategies which affects the outcomes of their respective returns.

Complexity vs Simplicity

The assumption behind active investing is that markets are not efficient, i.e. the prices of stocks are not truely reflecting its value and this presents an opportunity for them to correct it and make a profit.

What do I mean about this? Active investors seek out underpriced stock, buy them and sell at a higher price later.

Conversely, they may also actively seek out overpriced stock, short sell (selling securities which they do not own and buy them back at a later time) to reap a profit.

Active Investors Compete With the Market

To exploit pricing inefficiencies in the market, active investors need to compete with all other investors in the market to be the fastest to find mispriced stocks to make a profit off them.

The active investors often have to build complex forecasting models, create complex analysis considering multiple variables, employ strategies to maximise or amplify their gains in order to identify and exploit opportunities to profit faster than the rest.

Besides, with over 119k funds globally, it becomes hard for an investor to choose a fund. So how do funds differentiate themselves? Offer more creative and more complicated investing strategies.

Also, it justifies the higher fees, after all, a more complicated forecasting model and a sophisticated implementation strategy allows them to be a step ahead of the competition, right?

All these sounds good. However, the caveat is that competition may well be using equally complicated and sophisticated models and strategies, and they are not amateurs either but very smart, qualified and competent professionals.

Passive Investors Play a Different Game

For passive investing, the belief is that the markets are efficient, meaning all the prices in the market reflect their true value.

So there is no need to predict or identify stocks for there are no inefficiencies to profit from.

They believe in capitalism and that the markets will grow as a whole when the economy grows.

All they need to do is buy the stocks, wait for those companies to grow and profit from them later.

So the passive investing strategy is much simplier: buy and hold a diversified portfolio of securities and wait for them to grow over the long term.

In short, active investors play a different game from the passive investors. I personally prefer the passive camp because it is much simplier alternative for the unsophisticated investor.

Follow-up read: Winning the losers game by Charles Ellis

Being In Control vs Surrendering

In order to get a desired result, we must take control of it and correct our steps as it goes off course. This concept is established in our work places.

Similarly, we should be in control of our investments.

We select only the best companies in our portfolios. When the markets starts to fall, we take action to mitigate or cut our losses.

I totally get it, taking action when things go out of hand is reassuring because we feel that we are in control of the situation.

However, I might want to argue that the control active investing provides may not always produce the most reliable outcome.

Active Management Risk

In active investing, there is one factor that will largely determine the success or failure of the investment – the active manager. This is referred as active management risk.

With so many active funds to choose from, how will you choose a skilled active manager who can beat the market consistently?

We often look at their track record to choose a skilled manager but how much of their past performance is due to their skill or just luck?

Also, past performances does not guarantee future returns, and from the persistence scorecard from SPIVA, a report that tracks how consistent a top fund will continue overperforming, it seems unlikely that the top performers persist over a period of time.

Sometimes, top performers can end up at the bottom the very next year.

Let’s assume you already chosen a truly skilled active manager and all is well. What happens if the active manager leaves the fund? Will the new manager be able to maintain or improve performance of the fund?

Especially if you are investing for a long time horizon, this risk increases every year as the manager ages.

Human Biases

If you are a Do-It-Yourself (DIY) retail investor, this becomes even riskier because you are making all the investment decisions. You are the risk.

As a DIY investor myself, I know that overconfidence is one of the biggest pitfalls of DIY investors.

Well, I did my due diligence, I researched, followed trends and analysed every single detail, what could go wrong?

The problem is that there are probably thousands of others, industry experts, large professional full time teams doing the same research and trying to do the same thing.

Add to that, I have also human biases that will affect my judgement and decision making. And most of the time, we are unaware of our biases.

When markets crash, the instinct kicks in and suddenly you feel the urge to do something to save yourself from the sinking ship.

All these irrational behavior can lead to bad decisions which can lead to bad outcomes.

Passive Investing Limits Investors Involvement

In passive investing, we try to give up control and accept what the markets give. (or more accurately, what the indices give)

For passive fund managers, they just need to follow the index or the perscribed methology and schedule of buying and selling. Even if the fund manager leaves, another manager can easily replace him or her.

Sure, we might miss out great opportunities to make a quick buck. The passive fund manager is not going to speculate or follow a trend.

Even when markets do fall, passive investors do not react because they are focused on the long term – markets will go back up when the situation improves in the long run.

In large scale operations or productions, the most common error is often human error. Therefore, companies always attempt to automate everything not only to improve efficiency but also improve accuracy and consistency by removing the human factor.

Likewise, if we are the potential source of risk of our portfolios, we should try to stop actively choosing our stocks or timing the market but just rely on a discplined approach of investing regularly in index funds.

One caveat: we still need to have some control in passive investing – the selection of funds and asset allocation. Which I will cover in a later post.

Be Focused vs Spreading Out Too Thin?

“Never invest in a business you cannot understand.

Warren Buffett

This is very valuable advice. It can save you from losing a lot of money in investments that do not make sense. It can also profit you by playing on your strengths.

If you know the industry inside out and can spot opportunities, why not focus and earn the most out of it? That is why we have specialists.

However, there are two downsides to this approach

There are Always Other Experts

The first issue is the one I briefly mentioned in my previous points: the competition.

For the average DIY investor, we lose out to professionals when it comes to resources, time, access to people and information when it comes to securities research.

Even if you were able to predict better than everyone else, you may never be able to predict black swan events – events that cannot be predicted.

Like the Wuhan Coronavirus that suddenly appeared and devasted the airline and travel industry in China.

Or the assination of Iran’s top general that caused the oil prices to spike.

Or an extradition bill that caused an entire generation of Hong Kongers to protest in the streets.

You can be certain that there will be uncertainties in the market.

Missed Opportunity Costs

The second issue is if you abstain from investing in a sector just because you simply do not understand it, you may lose out on the opportunity costs.

For example, Warren Buffett admitted that he should have invested in Google and missed out due to his lack of technological expertise.

There are always new technologies or ideas that may work out. We can never fully understand everything.

So, that may limit our investments to what is familiar to us and miss out on the next facebok or amazon or google.

Diversification Reduces Risks

As the term is often heard: “The only free lunch in investing is diversification”, “Don’t put all your eggs in one basket”

Diversification reduces our risk by investing in a broad selection of uncorrelated assets.

If any one asset falls, you still have several other assets that are unaffected and your portfolio does not crash.

What About Returns?

Will diversification reduce our expected returns? Well, the answer here is it depends.

Imagine a two portfolios: One consists of value stocks in the US the other consists of growth stocks.

Value stocks are stocks that trade at lower prices compared to their fundamental and a high dividend yield. An example will be large bank stock.

Growth stocks are stocks that tend trade at higher prices due to their strong earnings growth potential. An example will be a fast growing tech company.

So over the past decade, if you held a portfolio of just value stocks you would have underperformed the market. So if you had diversified and included growth stocks, your returns would be higher.

If you had held a portfolio of growth stocks instead, over the same time period, your returns are much higher because growth outperform the market. If you had diversified your portfolio and included value stocks, your returns will drop to match the market.

The same can be said of country specific portfolios versus a globally diversified portfolio. If you held a Singapore portfolio you would have underperformed someone who had a US portfolio because the US market has outperform other markets globally.

The point is focusing your portfolio will result in a higher dispersion of returns – meaning you can have more different outcomes.

You can either outperform or underperform the market with a wide range of possible outcomes.

Diversification via an index will result in a lower dispersion and you will more likely follow what the market returns.

Diversification should be across different sectors and industries in the markets and across different countries.

Passive investing gives diversification by default. Investing in a global index gives you a diversification across all markets.

Do not miss out on great opportunities just because you want to avoid bad ones.

In Summary

If you can’t beat them, join them.

Aiming for average market returns via passive investing is the better strategy for many retail investors. This is an optimal strategy is is reliable and is easy to implement

To recap:

  • Implementing passive investing is much cheaper than active investing
  • Passive investing approach of buy and hold for the long term is simple and easy to understand. It is a different game compared to active investing
  • There is less reliance on individual skill in passive investing. Rather passive investing requires a disciplined and methodical appraoch
  • Passive investing offers diversification

Passive investing allows us to focus our times on our careers, skills and passions by eliminating the need to spend time on research or monitoring the market to wait for the next opportunity to buy or sell.

Our financial goals should support our aspirations and not become our aspirations.

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Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!