Passive Investing—How Hard Can It Be?

Investors are often confused about what passive investing actually is. One of the most common misunderstandings is that passive means not making any active investing decisions—another misconception is that passive investing is easy for investors to do. But passive investing is more nuanced and harder to execute than some investors may think.

What is passive investing?

Before we begin to look at the merits, or otherwise, of passive investing, it is useful to define it clearly. To do this, let’s first look at an investing style that is considered its opposite—active investment management.

To invest with an active strategy, portfolio managers buy or sell securities with the aim of outperforming a chosen index, or “benchmark”. In contrast, passive management is a strategy in which investors typically try to mirror their investments as closely as possible to a chosen index.

Of course, and as we will discuss, these definitions are not always clear-cut. For instance, choosing a passive strategy and deciding to follow a particular index are active decisions in themselves. And there are numerous other decisions you must make as well when choosing to invest passively: Should you track equities or fixed interest? Should you benchmark to an index focused on your home country or should you choose a global index? How should you change your investments if your goals alter over time?

Every passive investment strategy starts with at least one active choice—one that should be carefully considered, and would most likely benefit from professional advice.

Passive investing–what’s the appeal?

The hypothesis is simple: outperforming a given index is difficult, so it’s better to invest passively in the market and wait. Oftentimes investors attempt to do this by selecting a fund or several fund products. Over time your long-term investments will perform close to your chosen index and, it is hoped, better than if you had adopted an active investment strategy—for investors who adopt an active strategy are likely to make more bad decisions than good, and perform much less well than their chosen index. Passive investing products also can be less expensive than active money management, and those savings can add up. 

Passive investing—what’s the reality?

Even putting aside the fact that selecting an index to follow is an active decision, in reality, we believe few people successfully remain passive long enough to enjoy the perceived benefits and see their "hands-off" investment strategy perform as they believe it will.

Why do people have such difficulty sticking to a passive strategy? Well, for a start, passive investments tend to be easy to buy and sell. Although this liquidity is a benefit in the right circumstances, for individual investors it can become their downfall and the temptation can be to actively trade investments in a way that’s inappropriate for an overarching passive investing strategy.

However resolute a long-term investor might be about sticking to a passive investing strategy from the outset, it is hard to avoid selling up in a downturn—a course of action which potentially means missing out on the gains of the subsequent bull market. Similarly, it can be difficult for investors not to be drawn to the excitement of a "hot" sector—for instance, technology stocks in the 1990s. It is easy to get caught up in false dawns. Imagine an investor who sees herself as passive, but changes her benchmark from a broad, global index to one tracking a specific hot sector. Things can change very quickly and if that hot sector crashes, there will be a risk of experiencing more volatility than would be present in a broader index. Over the long-term, this could increase the risk of failing to meet one’s investing objectives.

In short, passive investors may end up making active decisions in changing their benchmark or trying to time the market. Get a timing decision wrong could mean your portfolio lags behind the market significantly. This wouldn't be too problematic if passive investors could remain truly passive, but the problem is investors are humans and often react emotionally.

To try to resist this temptation is to try to override basic human psychology. In our view, the best way to avoid emotional decisions in the face of either hype or volatility is to seek help from an experienced financial professional, who can guide you through the noise and to keep you disciplined through all the times of short-term temptation. Unfortunately, even this may not always be as easy it appears.

Everyone thinks they’re different

It is easy to think that you are unlike other investors, that somehow you will stay disciplined to your original passive strategy when others do not. However, the reality is that everyone feels like this. Market research firm DALBAR, Inc.’s annual study, The Quantitative Analysis of Investor Behavior (QAIB), compares stock and bond market returns to average American mutual fund investor returns over the preceding 25 years. While this study was conducted with American investors, we believe the core human behavior it shows isn’t specific to any one country or set of investors. The QAIB, ending December 31, 2017, makes this point:

“The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to execute a long term strategy. In fact, they typically stay invested for just a fraction of a market cycle.”

The biggest reason for this? According to QAIB, it is “psychological factors” leading to poor market timing. Whether it is loss aversion or misplaced optimism, the emotional nature of being human does not make for natural investing or a preference for long-term investments.

Fisher Investments can help review your portfolio and keep you on track

Fisher Investments UK can carry out a complete review of your portfolio and provide associated financial advice. Questions we address include whether your investment decisions and asset allocation are appropriate for your long-term objectives and future income and spending needs, and whether there is any overlap in your portfolio’s underlying assets. We perform a technical analysis of your trading strategy to provide a high level investment plan that's tailored to your goals.

For further information, contact us today.

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.