Over the past several years, investors and experts have debated passive vs active investing. Passive investing refers to buying low cost index funds where stocks in the portfolio seldom change. Active investing refers to paying higher fees for a professional money manager to make tactical buys and sells of stocks in a portfolio.
I often get asked…which is better for an investor, active or passive? My answer is always the same. It really doesn’t matter that much because we are focused on the wrong thing. The return we earn through investing is more about whether we are an active or passive investor rather than using active or passive investments.
It’s a Behavior Thing
Depending upon the study, researchers have found that the behavior gap causes a portfolio drag of 1% to over 3% per year (on average). But averages tend to skew reality. Some investors have a plan and set a defense to help them make better decisions. Many have not. For those that have not, the drag on performance due to their decisions is much worse than the average. The average is skewed higher by those that behave well.
Take spring of 2020 as an example. Anyone who sold in March when the market went down 35% and remains out of the market lost out on significant upside…way more than just 3%. Not only does the investor miss out on the gains, but lives with that regret (or the stress of making excuses) and now must guess when to get back in. Market timing not just losing money; it adds incredible stress to our lives.
Change the Narrative
There may be times when the passive vs. active investment debate has merit. It can have merit when everyone is a rational investor or when things. Economist David Rosenberg, just today, opined that the biggest bubble currently is passive index investing. His viewpoint is largely centered on valuation, easy money and the fact that he believes there are valuable equities not represented well in indexes.
Investors love their passive indexing because of low fees and because that is what the media has been telling them for years. You may love them too. I do for certain aspects of the portfolio. But there is no doubt we spend too much of our attention on passive investing and not enough time helping our clients become passive investors. The active investor is one that has an itchy finger, likes to trade and reacts to events. The passive investor is one who is confident, has a strategy, and couldn’t care less about the news story of the day or how the market performs over a short period of time.
All else being equal, low cost investments always trump higher cost alternatives. But, all else is not equal. And investor behavior trumps all when it comes to the return on our investments.
Related: Being Green With Envy Is a Characteristic Investors Should Avoid