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.

To be sure, each year, about one-third of active mangers will earn market-topping returns, estimates Steven Evanson of Evanson Asset Management in Carmel, Calif. The problem is that no one can predict which one-third that will be, since historical performance offers no clues as to how well a manager will do going forward.

That’s because what we call “the market” is simply the sum total of individuals’ investing decisions, says Larry Luxenberg, partner with Lexington Avenue Capital Management in New City, New York. As a result, “returns have to be the market, less expenses,” he says.

One criticism of passive investing has been that it doesn’t protect investors in declining markets. Instead, investors simply go down with the market. While that may be true, the ability of active managers to get in and out when it’s optimal also is limited, Evanson says. “They’re no better than chance at predicting when to exit and enter the market.”

Does all this mean that active management has no role to play? “I wouldn’t say that I would never recommend active management,” Luxenberg says. Active management is less effective in the U.S. stock market because it’s efficient; that is, stock prices tend to reflect available information. This limits the ability of managers to add value by picking certain stocks, he notes. Other markets, like the real estate market, are less efficient. Here, active managers are more likely to be able to identify bargains or add value.

Related Stories:

Recession Opportunities: Green Investing

Beginner's Guide to Foreign Exchange Investing

10 of the Top Selling Money Books

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

Show Comments

Back to Top