Why Doesn't Everyone Use Passive Investing? (771 hits)
As an investor I try to stay in it for the long run. I have a certain percent of my investement that I use as active investing though I have to admit I am now holding down the reins and am in watch and hold mode now. But for all of ya'll that have a little disposable income instead of buying that new outfit, those shoes or whatever try to invest it and then go out and buy yourself something. One of the keys to building and maintaining wealth is through careful investment. This article deals with an old fashioned (i love old school) way of investing. This type of investing also helps build stable economies and communities and lesson the volitility that we've been seeing in the markets of late.
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 30 years overwhelmingly endorses this approach.
Before we get back to the question, let's briefly explain passive investing. Until 30 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.
In its simplest form, passive investing involves trying to match a segment of the stock market by assembling a group of stocks and holding on to them indefinitely. A passive investment manager makes changes only when necessary such as when a company is acquired or the membership of an index shifts. The most popular form of passive management involves trying to match the performance of the S&P 500 index or the NASDAQ Composite Index. In recent years, however, many innovative forms of passive management have sprouted up.
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? 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.
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 leap in passive investment theory and practice is sufficiently large as to constitute a second revolution in passive investing.
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 result. 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.
Larry Luxenberg, is portfolio manager and partner at Lexington Avenue Capital Management. He can be reached at larry@lexingtonave.com.
