Why is passive investing better for investors?

Date Published:24/01/2008

After the culinary excess of Christmas, many of you will possibly now be making regular visits to the gym in order to lose a few pounds. Active investing is a little like going to the gym. The more active you are, the more pounds you may lose. It is very easy to understand how you will be drawn towards the seduction of active management. It really would be exciting to dip in-and-out of markets, making timing work in your favour and snapping up bargains which can be sold for a profit.

Research supporting passive management comes from universities and privately funded research centres, not from City firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in their own huge profits available from active management. The results from this research are very clear: Active investment management is an appealing mirage which substantially boosts costs and decreases returns compared to properly designed passive portfolios.

tratfordians will all have seen the various ‘wealth warnings’ advising that past performance is not an indication of future performance.

Other active management wealth warnings should perhaps include statements like, ‘our crystal ball is no better than yours’ or, ‘we are more than happy to gamble with your money, as long as you pay us plenty to do so’. The objective for you should not be to beat the market but to use proven methods and investment strategies that will generate sufficient investment returns to ensure their own objectives and desired lifestyles are achieved. You must get a financial plan so you know what returns are needed; review the costs of funds bought and invest in passive funds to control risk and returns.

An appropriate passive investment strategy is designed to ensure that you keep as much of your money as possible, whilst providing expected returns.

A passive fund manager adopts a buy-and-hold approach to money management designed to generate the highest possible returns for the investor.

A passive strategy sees no merit in trying to pick individual winners amongst equities, or in trying to time market swings. This type of strategy is active and numerous studies have shown that an active strategy simply does not work!

Passive investing is significantly cheaper than active investing. Lower costs mean greater returns for investors.

Passive investments funds outperform average active funds by 1.8% per year.

You may well cite a number of examples of consistently outperforming active managers such as Neil Woodford, Anthony Bolton, Peter Lynch or Warren Buffett.

However, the difficulty is in knowing today which managers will be the ones to outperform for the next 10 or 20 years. Consequently, the odds of selecting one of the future performers are very low.

It may come as a surprise that the two greatest superstar active managers of our time, Warren Buffet and Peter Lynch, both recommend passive investment as the best strategy to adopt.

The “Smart” Money uses Passive Investment Strategies. An estimated 40% to 50% of all institutional investments are in passive portfolios while only 3% to 4% of retail investors currently make use of passive strategies. However, watch this space!

Active investing is like buying a lottery ticket. Whilst you have the lottery ticket, you can dream the dream. However, the odds of beating the market over time are analogous to winning the lottery jackpot: Possible, but highly unlikely.

Next time I will look at the importance and impact of costs on achieving your own financial objectives.

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