The Case For Passive Investing

In this article I explore the case for passive investing, including the benefits and costs. Let’s start with the definition.

Passive Investing

• Passive investing is simply putting together a long-term portfolio and letting it grow
• One of the strategies for a passive investor is to purchase an SP500 or TSX60 ETF and hold it for a long-term
• Passive investors don’t analyze stocks, markets, PE ratios, dividend yields
• Passive investors do watch the news but they don’t act on them, unless they want to add more money to a passive portfolio

Active Investing:

• An active investor constantly analyzes investments, markets, PE ratios, Book values, reads the news, and makes purchases and sells stocks based on this information.
• Active investor reads stock research reports, looks at CEO actions, analyzes company capital structure, and uses various models to value a security
• Active investors ultimately believe that they add value by their analysis and wisdom.

Let’s look at some facts to see which strategy is more valuable for investors:

• Time Efficiency: passive investors spend much less time on their investments and analysis of their portfolios. They adopt a passive investment strategy and rebalance their portfolios once a year. Active investors, on the other hand, have to constantly watch the market, read the news, watch government actions, and invest accordingly
• Transaction Costs: since passive investors do not buy and sell on a regular basis they don’t pay as much in commissions
• Manager Costs: since there is no need to have extended investment analyst personnel annual fees on passive ETFs are much cheaper.
• Tax Consequences: active investors buy and sell all the time based on market opportunities, and thus they trigger tax consequences. This mostly applies to non-registered accounts.
• Performance: some active traders or managers are really smart, and are able to outperform passive strategies. However, this outperformance is limited, and is not consistent

Facts and Studies:

• There have been multiple studies demonstrating superiority of passive manager. For example, according this 2019 study by CNBC 85% of active managers underperformed their benchmarks over a 10 year period.

• It is interesting to see that over 1 year, only 61% percent of active managers underperformed SP500. This claim is reasonable. Can active management be successful?
• For example, another study by FT Advisor found that most active managers in the UK outpeformed an index in 2020.
• Although 2020 has been a good year for active managers , I have been unable to find any studies that have shown active managers outperformed passive investing in the long-term. In the same article FT Advisor cites another study explaining that between 2015 and 2020 only 40% of active managers were able to outperform their benchmarks.
• All these facts demonstrate the importance of long-term investing and sticking with your plan.
• Yes it is possible to outperform SP500 or another index if you find a superior fund manager. However, most investors (including myself) do not have this superior ability to pick such manager based on a skill.

Your Personal Philosophy and Other Considerations

• Talent and Luck: some investors are very talented or lucky. A few of my friends in the investment world have been able to make millions of dollars using option strategies (that are highly risky). It is possible to get rich quick with high risk instruments. However, this does not apply to me. I am simply not that lucky.
• Entertainment: stock trading is a great way to entertain oneself in your free time. You win, you loose, you breakeven … There is excitement, drama, ups and downs, occasional margin calls and sleepless nights, and a few victories in between. Everntually, though, some investors get tired or bored and move to another form of entertainment.
• Time: Do you have time to do company research? To analyze present value models? Read economic reports? Listen to Fed Announcements? Or do you have family and job commitments that are more important?
• Picking stocks: Do you think picking stocks is a right strategy, or do you believe in long-term investments?

Conclusion:

It is possible to outperform the market on a short-term basis, or on a long-term basis for very skillful investors. However, for me personally it is no longer worth the hassle.