Why Doesn’t Everyone Use Passive Investing?
Recently I talked with a couple about our approach to investing. The husband had spent a lot of time on it and grasped all of the nuances. The wife said she was a little befuddled but after several hours of conversation, examining charts and tables of numbers, she finally asked: If this is so good, why doesn’t everyone use it?
I fumbled around for an answer but couldn’t come up with anything compelling. It’s a good question because most people don’t use passive investing even though the experience of the last thirty years overwhelmingly endorses this approach.
Before we get back to the question, let’s briefly explain passive investing. Until thirty years ago, everyone was an active investor. That is, they tried to pick the best stocks, bonds and mutual funds and hoped to come out ahead of all the other market participants. But starting in the mid-1950s, academics began to theorize that investors doing this were simply engaged in an expensive and ultimately futile effort, chasing this dream and usually falling far short of where they should be.
An Investing Revolution
Eventually this theorizing and a gigantic bear market spawned the beginning of the passive investing revolution in the 1970s. To the extent that people know passive investing at all, they associate it with index funds as popularized by John Bogle and the Vanguard Group. In keeping with the lethargic name, in this approach, instead of trying to “beat” the market, investors keep costs low and merely try to come as close to the broad stock market returns as possible.
While this strategy may not sound exciting, think again. This simple strategy over time beats nearly everyone – at least 99 percent of investors. This includes most mutual funds, nearly all of those smart people you see on TV and read in the newspapers, the vast majority of those people frantically yelling on the floor of the New York Stock Exchange and nearly all of your neighbors. When people talk about the stock market, they generally emphasize their winners, but the real tally is often a quite different picture.
How can this be? You might ask. With all these smart people working so hard and listening to the best minds, why can’t they beat this simple, mindless, mechanical formula? The main reason is that there are so many smart, well informed and hard working people chasing this same dream. Yet another reason is that people are human and ill equipped for this particular task. They are emotional and energetic and opinionated and they can only focus on a limited number of things at one time. All of these things lead to critical mistakes that diminish performance.
Finally, people can’t leave well enough alone. Nobody wants to merely beat 99 percent of other investors. They want to beat them all. In the process, despite their initial hopes, they end up inflicting significant financial damage on themselves and often an emotional toll as well.While the simple mechanical formula works surprisingly well, we believe that using these same insights, there are ways to capture significantly better performance without increasing risk exposure. The original indexers focused on standard industry benchmarks. The oldest and biggest is the Standard and Poor’s 500, which consists of 500 of the biggest and most important U.S. stocks. The problem now is that too many people mimic the same few indices and so it’s gotten intensely competitive. When an “index” reshuffles its membership, everyone has to buy or sell at the same time no matter what the cost. Stepping outside this process is a big benefit.
A Second Revolution
In response to these problems, other passive investors have created their own collections of stocks and by building in a modest degree of flexibility find that the payoff is huge. They may also target specific segments of the financial markets. This is much harder than it sounds but if it is well executed, this innovative approach makes a big difference. This leap in passive investment theory and practice is sufficiently large as to constitute a second revolution in passive investing.
A related development in passive investing is an increased emphasis on investing overseas.Most U.S. investors focus too heavily close to home – they need to be more adventurous and spread out around the globe. While the U.S. remains the preeminent economic power, the rest of the world is gaining on us. Many nations are growing much faster than the U.S. and given our already large and successful economy, the relative growth is likely to endure.
Finally, passive investing requires patience and does not furnish the excitement that active investing does. There are no stories to tell, no triumphs to celebrate. The only thing exciting about passive investing is the results. By taking a small sliver of thousands of stocks worldwide and hewing to this system for many years, an investor has the best chance of reaching his goals and preserving and accumulating wealth.
It’s dull, it’s boring, it requires sitting still and a lot of humility but in the end passive investing works and what’s the matter with that?