Why Passive Investing Is A Great Choice

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One of the things I’ve found most interesting in the feedback I’ve received with Portfolio Charts is the diversity of people who appreciate it.  Whether it’s an investing newbie eager to learn about index investing, a an experienced investor comparing portfolio options, or even an occasional professional fund manager interested in the calculation methodology, it’s exciting to see so many people find value in the clear and unbiased representation of good data.

In an effort to offer a helping hand to the first of those groups, I created a new page to outline the basics of how to use the information on the site to build and manage a portfolio of your own.  It’s just a start, and I do plan to expand that type of information over time, but luckily it’s really not that complicated!  So if you’re new to investing or know someone else looking take the plunge, that’s a good place to start.

But every good explanation of “How” deserves an equally good explanation of “Why”.  This is something we all need to be reminded of occasionally no matter where we are in our individual investing experience.

 

Why is passive index investing a good idea?

 

Of course there are lots of good reasons, but allow me to present a few of my personal favorites.

 

It’s the best use of your time

Plenty has already been written on Warren Buffett’s opinions on index investing.  If you’re not up to speed, the most famous and successful active investor of all time recommends that most people simply stick to passive index fund investing and plans to do that with his own estate after he’s gone.  On the surface, that seems kind of strange.  But when you get down to it, Buffet is simply being refreshingly honest and self-aware.

Buffett has been hugely successful as an active trader.  But he is also uniquely talented and privy to information and opportunities the rest of us will never have access to.  And even more importantly, he dedicated his entire life to investing — a sacrifice most of us are unwilling or unable to make.  By noting that most investors would do just fine with a passive asset allocation, he verbalizes the old 80/20 rule that affects so much in our lives.  80% of the investing benefit can be achieved with very little effort at all, while the last 20% is tremendously difficult.

Rather than dedicating your own life to squeezing out that extra bit of return, you’d very likely end up much better off financially by spending that time advancing your career or negotiating a raise.  You may not be as talented an investor as Warren Buffett, but he is not as good of a teacher, firefighter, or engineer as you are.  Making money and saving for retirement is about so much more than squeezing the last basis point out of investment returns.

By investing in a passive asset allocation, you maximize the tradeoff between the returns and the effort required to achieve them.  That will free you to pursue personal interests far more profitable and enjoyable than reading corporate filings all day and watching the markets like a stressed-out cat with one eye on the mouse and the other on the dog.

 

It’s the best bang for your buck

Of course, even if one does not want to do all of the work that Buffett does, why not hire someone to do it for you?  Historically that person has taken the form of a mutual fund manager or private investment adviser, but today it is also filled by robo-advisers and PhD-backed investment algorithms.

Now all of these options have their place, but they do share one thing in common.  They’re not free.  The average expense ratio for an actively managed mutual fund today is about 1.3%.  That may not sound like much, but consider that the long-term inflation-adjusted CAGR of a typical 60/40 index blend is only about 5%.  So on average that 1.3% fee represents about 25% of your potential profits that you could achieve by using a similar passive portfolio.  That’s a big handicap to overcome, and this is why numerous studies have shown that even when some managers do manage to beat the market before fees, inexpensive index investing is usually more profitable in the long run.

Robo-advisers are usually a better deal, with fees around 0.3%.  They’re created by very smart people, and I trust they offer reasonable advice.  However, consider that they accomplish lower fees by offering a smaller number of portfolio options that invest in index funds with an asset allocation selected for your risk tolerance.  Now that’s an excellent service that may be appealing to a lot of people, but proactive types may wonder why they should pay 0.3% a year when they can get similar information on a site like this one with portfolios recommended by equally-credentialed experts for free.

I think the most common answer to that question is simple fear and insecurity.  Most people don’t trust themselves to do something that seems so complicated.  Which leads us to the next point….

 

It’s really easy

Investing is intimidating.  I get it.  Maybe you don’t see yourself as a numbers person, and don’t trust yourself to make the best financial decisions.  Maybe you hold out hope that surely there’s someone way smarter than you who can do even better.  Or maybe the constant drone of ever-changing financial news has rightly convinced you you’ll never be able to keep up and must outsource that effort to someone else.

But wise investing really isn’t that difficult.  You don’t have to beat the markets to be successful — growth is built in!  You just have to pick a battle-tested plan and stick with it.

The hardest part is finding a portfolio that works for your personal financial and emotional needs, which is why so much of this site focuses on data and examples to explain the tradeoffs associated with different investment decisions.  But running your own passive portfolio is extremely simple to do and only requires attention once a year.  If you need a primer, check out my previously mentioned guide on how to manage your own portfolio.

 

It makes you a better investor

Being a passive investor does not mean you are blind to the markets.  To the contrary, a wise investor can quantify the natural uncertainty of a particular portfolio and select one that maximizes return for the risk.  Now that requires a lot more information than you typically find in asset allocation discussions, but luckily there are lots of tools to help.

By knowing how and why you invest the way you do and by taking the time to truly understand not only the average return you hope to receive but also the turbulence you may expect along the way, you build an educated level of discipline that the average investor does not enjoy.  This discipline is critical to weathering inevitable market storms, and that ability to stick with the plan has a measurable positive effect on your long-term returns.  In fact, by making it too complicated the average investor is their own worst enemy and the average professional doesn’t do much better.

Taking charge of your own life savings and forming a simple set of rules you can stick to will make you happier and wealthier in the long run.

 

A note on other options

So is passive index investing the only good option for reasonable investors?  Of course not.  Just like there are different portfolios for different types of people, there are many investing methods as well and I’m not so quick to dismiss them just because they do not align with my own.  I can absolutely see the benefits of dividend growth investing, company valuation metrics, income-producing rentals, and other trading strategies that have made some people very wealthy.  For every person who points out that Warren Buffett recommends that his wife put her money in simple stock and bond index funds, I’m still very aware that Buffett himself amassed all of that money by following absolutely none of that advice.

So please make no mistake — My goal is not to talk you out of anything but to offer a positive message for why passive asset allocation is a great option to consider.  It may not ultimately be for everyone, but I believe it can work for anyone.  Whether you’re a new investor looking for simple but effective options, an experienced active investor considering alternatives to your own plan that maybe isn’t working like you hoped, or even an investment professional seeking new ways to connect your clients to strategies they can appreciate and stick with, I recommend taking the time to read up on the many good options available.

Investing doesn’t have to be so difficult.  Plan wisely and keep it simple, and the returns will come to you.