Passive Investing Is Power Investing

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Passive Investing Is Power Investing

The Feds may or may not raise interest rates again in 2018. Europe’s economy may or may not recover anytime soon. A correction may come that causes some investors to panic and others to benefit from the dip. It’s business as usual in the markets, with the usual mixed messages tempting individual investors into trying to time interest rates, predicting global economies, or forecasting the market’s next turn.

Is it really worth risking your retirement savings playing a timing game? The temptation to time the market or pick the next winning investment is best avoided. The more often you play this active management game, the more investment horsepower you tend to sacrifice.

Instead, empower yourself and your portfolio with passive investing. “Passive” is actually a bit of a misnomer; it’s not about doing nothing, but rather it’s about reaching your goals through deliberate action. Creating the right portfolio allocation from the start, participating in the markets cheaply through index and exchange-traded funds, and not speculating on the near-term future of the markets by trying to time your trades. By helping you stay on course and keep your money otherwise wasted on unnecessary investment expenses, I believe that passive investing can help you reach your financial goals.

I published The Power of Passive Investing to encourage this preferred strategy for all investors to follow. Packed with academic studies, this book shows the hard facts about the failure of active management and the fund companies who profit while their investors do not. It cuts through Wall Street hype and exposes those whose only interest is to make money from you, not for you. John Bogle, the founder of the Vanguard Group, graciously wrote the book’s foreword, and the Bogle Financial Markets Research Center generously provided mutual fund research used in a portion of the book.

While the particulars in the book may have changed – with new crises du jour to trouble us and the latest hot stock tips to tempt us – the book’s lessons remain as relevant today as they’ve ever been. This seems like as good a time as any to share some of the most powerful excerpts from The Power of Passive Investing:

Investors should select the best way to manage their portfolio so as to have the highest probability for success.

Finding an actively managed mutual fund that delivers alpha is a challenge for any investor. Trying to select a portfolio of active funds that outperforms a portfolio of index funds is another matter entirely. The odds of a portfolio using actively managed funds outperforming an all index fund portfolio is much lower than a single fund, and the odds drop with each additional active fund added to a portfolio, and the longer the funds are held.

Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!

(Note: for more information on index fund portfolios verses active fund portfolios, see “A Case For Index Fund Portfolios”, A White Paper by Rick Ferri, CFA, Portfolio Solutions® and Alex Benke, CFP®, Betterment, and winner of the S&P Dow Jones Indices Third Annual SPIVA Award for excellence in research on the topic of index-related applications).

Investors who are seeking alpha are looking for skilled managers, and this assumes skill is identifiable. Is it? About one-third of [surviving] managers beat the market over a five-year period, but are all these managers skillful? Are any skillful? Perhaps the winning managers just got lucky.

Often a manager has one or two big winning years and then their performance fizzles out. Where there’s no consistency, there’s no talent. It should be no surprise that most winning active managers don’t have consistency, which means they don’t have skill. They just got lucky.

If it’s possible, as some claim, to select skilled fund managers in advance, then what’s the methodology for doing so? It certainly would have been revealed in academic studies by now. Do such studies exist? If so, what’s the secret?

By far, the two most popular factors used in fund selection by the public are past performance and fund ratings. Other factors are fee analysis, the amount of assets in a fund, and qualitative factors such as where the manager went to college. Unfortunately, I was unsuccessful in identifying any comprehensive study on mutual fund selection that provided evidence that a successful fund selection method exists.

There were a few studies that suggested ways of narrowing down the field by eliminating funds that had certain characteristics such as the highest fees, or only including funds that had certain qualitative features such as a large personal stake in the fund by the manager, but no single factor worked consistently.

Recall that the very reason academics began studying mutual funds in the 1960s was to discover managers who had skill. Their efforts were unsuccessful back then and new efforts remain unsuccessful today. If the Ph.D.s can’t figure out how to pick winning managers, then it’s not likely that an individual investor or investment advisor is going to do it.

As one Amazon reviewer put it, The Power of Passive Investing is a comprehensive study that “sticks a fork in active investing starting in Chapter 1 and by the end of the book it’s a virtual blood bath. … While I had heard many of the arguments before, I’ve never read such a concise summary of the debate. And at the end it really crystallized my understanding of the market and how active funds underperform the market relative to their costs.”

If you’ve not yet read The Power of Passive Investing and “A Case for Index Fund Portfolios”, you may find it perennially helpful to your investing. If you have read it, a refresher may help your thinking stay on the right track.

By | 2018-05-25T20:35:07+00:00 May 9th, 2018|Markets, Strategy|0 Comments

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