A lot of people, when they think of investing, probably think about Wall Street, trading stocks and active fund managers. That’s because for a very long time this was by far the most common way to “invest” and actually it still is. But ever since John Bogle (founder of Vanguard) introduced the first index fund in 1976, there has been a huge shift in investing from active management to passive management or passive investing. It’s a shame they call it that in a way, because passive has a slightly negative connotation to it, don’t you think? Like it’s a pushover or not doing anything. On the other hand, active management sounds positive and assertive and probably has people feeling like active is better than passive. Anyways, getting back on track here I’d like to share why I strongly prefer a passive investment approach and why I believe for a lot of people this is probably the way to go.
First, what is active vs. passive investing? In active management/investing a person is essentially trying to “beat the market.” They believe in market timing, trying to buy stocks low and sell high. When an ordinary individual does this, it’s usually called daytrading, but financial professional do this kind of stuff too for their clients as portfolio managers or fund managers. Anyone who has tried daytrading or knows people who daytrade probably knows that more often than not you lose more than you win. I take it back, they probably don’t know this, that’s why they are daytrading. In an actively managed mutual fund, an expert is picking stocks and regularly trading them, again with the intent to outperform the market. Sounds great but oddly it’s not. First, they actually don’t beat passive funds very often. And while they may occasionally be able to generate higher returns than a passive fund, the high fees associated with active mutual funds or tax inefficiency invariably eat away at any extra earnings, after all these active fund managers don’t work for free. In passive investing, you’re not trying to beat the market, more like you’re trying to get your fair share of the market returns so to speak. The preferred investment vehicle of choice is an index fund or exchange traded fund (ETF) which can track an index like the S&P 500 and as such be invested in all the S&P 500 company stocks at once or even the entire US stock market. Heck, there’s even a total world stock market index fund and ETF. The cornerstone of passive investment is to “buy and hold” a broadly diversified basket of stocks and bonds. So while it’s not as exciting or potentially as lucrative (I said potentially, remember blackjack and poker in Vegas is “potentially lucrative” too!) as stock picking, passive investing creates three excellent advantages for average investors like me looking for a low maintanence way to invest and seek growth: low fees, tax-efficiency and simplicity. Let’s discuss further in depth below.
Low fees/expense ratio: Since there is no active manager to employ, busily trading stocks, liquidating holdings, generally index funds can be very cheap at a price tag as low as 0.2% and below. Vanguard for example offers the total US stock market fund, admiral shares (VTSAX, minimum investment $10,000) at an expense ratio of 0.05%! Contrast this with an actively managed mutual fund where an “expert” hand picks stocks and is actively trading, buying and selling stocks. Fees in actively managed mutual funds can run around 1% and sometimes higher. I saw this simple example once that showcases the power of compounding and how fees and taxes can eat away at your returns. In the first column you have Kathy’s money that gets to double without anything removed from her principle and in the second column is Alyssa who gets just 7 cents removed from her principle before her money gets to double. You’d think a 7 cent fee/tax isn’t much, but look what happens over time. After 21 cycles, Kathy has $220,200.82 MORE than Alyssa even though only a total of $1.47 was removed from Alyssa’s principle! I know this is an oversimplified example, but this is the power of compounding and the danger of fees and taxes. Even if only 1 cent was removed each cycle, Kathy would still end up with over $30,000 more than Alyssa. Do not underestimate fees in investing.
Tax-efficiency: Index funds tend to be more tax efficient than actively managed mutual funds. Within an actively managed mutual fund, there tends to be higher portfolio turnover because the manager is probably frequently trading, buying and liquidating stocks within the fund. Higher turnover generally means higher capital gains and taxes. There are two types of capital gains, short-term and long-term. Short-term capital gains (profit from stocks held less than 12 months) are taxed as ordinary income so whatever you’re highest marginal tax bracket is, i.e. 25% or 28%, that’s what your profit will be taxed. Long-term capital gains (profit from stocks held greater than 12 months) are taxed at a lower rate, generally 15%. Within an index fund however, there tends to very low turnover since the index fund is either holding a large group of stocks tracking a broad index or the entire stock market. And since the investment philosophy is to “buy and hold” there isn’t much selling or trading going on. Loss of your earnings/principles to taxes is another reason why actively managed funds usually fall behind a passive approach.
Simplicity and low maintanence: One of the other great things about using passive index funds is its simplicity and low maintenance. Most of us are not full time investors. We have full time jobs and may also be married with kids and as all parents know that’s another full time job within of itself. Needless to say, parent or not, most of us don’t have a ton of free time to monitor the stock market every hour for changes and opportunities in trading. Nor do we have extra money to burn. Instead by constructing a broadly diversified portfolio with as little as 3 index funds, you can create a passive portfolio that you set and forget! Well at least for a year or so. You should periodically rebalance your portfolio to make sure it remains on target. For example, the famous 3-fund lazy portfolio is just the Total US Stock Market, Total Bond Market and Total International Stock Market (the percentage you use of each fund should be based on your target asset allocation which should be determined by taking into account your investment timeline and risk tolerance). If you used Vanguard’s index funds, your total expense ratio for these 3 funds (assuming you met the minimum for investment) would be ~0.19%. Simple, low maintenance and cheap! Not to mention equal or greater returns compared to an equivalent actively managed fund. According to Burton Malkiel in his book A Random Walk Down Wall Street 2/3 of professional portfolio managers have been outperformed by an unmanaged S&P 500 index fund. Can you see why me and many others are fans of passive investing?
The bottom line is that buying and holding a broadly diversified portfolio of stocks will likely produce equal or greater returns than their active counterparts and are generally significantly less expensive and simple to construct and maintain. Even if active managers were able to outperform a passive index fund, their fees and any possibly any taxes ate up the returns and caused them to underperform overall. Even the “Oracle of Omaha” himself Warren Buffet advises that most investors should just invest in index funds. The truth is just because you know how to invest like Warren Buffet doesn’t mean you can. I might have the recipe for Emeril Lagasse’s famous Gumbo or Osteria Mozza’s Butterscotch Budino, but that doesn’t mean I can make it just like them. More likely, it’s probably going to look and taste differently. So do yourself a favor and take the easy road. It’s probably one of the few times in life taking the easy road is also the more profitable road. Now if you really enjoy picking stocks and daytrading or believe your financial advisor or fund manager is the cat’s meow and can outperform the market, well you are certainly entitled to invest that way. Just don’t say I didn’t warn ya! ?