When Passive Investing Pays Off

It may seem that trying to beat the market average when you buy stocks is the logical approach to investing. After all, who wants to settle for average?

However, trying to do better than the market, or what’s often referred to as “active investing,” actually can leave you worse off than its counterpart, which is known as “passive investing.” Passive investment managers invest in broad sectors of the market with a goal of matching, rather than topping, the market returns for that asset class.

It may seem counter-intuitive that a passive investing approach could beat an active one, but the evidence is compelling. For starters, active management is more expensive than passive management. In a 2002 speech, William Sharpe, emeritus professor of finance at Stanford University, estimated that active management costs at least 1 percent more annually than passive management.

While that may not sound like much, consider that over the long run, stocks typically return between six and eight percent. Lop a percentage point from that, and you’ve lost between 13 and 17 percent of your potential return.

Moreover, a number of studies (other than those done by investment firms) show that the likelihood of any one person consistently and accurately timing the market is almost zero. Take an April 2009 study with the rather ominous title, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” by Laurent Barras and Olivier Scaillet with the Swiss Finance Institute, and Russ Wermers of the University of Maryland. The trio studied the performance of 2,000-plus funds between 1989 and 2006. They found that just .6 percent of fund managers were able to beat the market over that period.