This post is from Ryan Modesto, Managing Partner at 5i Research, a fan of My Own Advisor.
Momentum behind passive investing continues to gain steam and with it, a large and vocal group of supporters has been building. The passive versus active investing debate has been going on for some time and holds a similar degree of rivalry as the Toronto Maple Leafs versus the Montreal Canadiens or Peyton Manning versus Tom Brady. But as of late, it seems like passive investors have been gaining an edge, edging out the voice of active investors, chasing them back into their caves where they are forced to wait for a few good years of alpha generation before they poke their heads back out. This trend is especially gaining popularity in the financial blogosphere where many have freed their mind from the movements of their stock portfolios and picked up the passive banner. Even My Own Advisor has written about his desire to have more “core” to go with his “explore”.
To be clear, the trend of low-cost, index investments has been nothing but good for investors and retail investors are the big winners using low-cost Exchange Traded Funds (ETFs). In a large number of cases, passive indexing makes sense. It is easy, not overly time consuming and cheap. Not to mention, stats back up the effectiveness of passive investing over active with time. It is also a great way to gain diversification. In almost any case, an ETF is probably the better choice over a single security but active investing also often gets picked on for reasons that are not totally fair and generalizations that really do no one any good. So lets look at a few reasons why active investing is worth defending:
Degrees of active/passive – It almost seems that to be a passive investor, you can only own indexed funds or ETFs and you need to hold them until you’re 99 years of age. Many overlook that you can still be a passive, buy-and-hold investor that owns dividend stocks without owning a fund (and without paying the fees). Just because an individual owns securities, does not mean that they are throwing caution to the wind and ignoring all of the data out there suggesting the superiority of passive investing.
You are more active than you think – I flesh this point out a bit more here, but guess what: If you own the TSX composite, you are essentially making an active bet on energy and financials as the market-capitalization index is heavily weighted toward these two industries. Just because an investor is holding what everyone else is holding (the market) does not mean it is necessarily safer, it just means you will do as good (or bad) as everyone else.
Necessary part of a functioning market – In order to have a properly functioning market, there needs to be price discovery. These are the active investors who are trying to decide what assets are worth and how much they are willing to pay for future earnings. Without this price discovery, passive investing would not be able to exist.
It is possible to beat the market – It is hard, it takes time and it takes effort, which are many things the average person does not have the time and resources for. But to say beating the market is impossible is not totally fair. There are the popularized managers such as Warren Buffet that everyone knows about but there are others out there with good track records. To be fair, however, there are probably a lot more failures out there than successes.
Retail investors are not fund managers and that’s a good thing – Retail investors do face a disadvantage, as they do not have teams of analysts and expensive data resources at their fingertips. However, they do have some advantages over funds. First, their job does not depend on investment performance and they in turn do not have to make aggressive decisions or trades they would otherwise not make if their job did not depend on it. Secondly, you only have to answer to yourself. You do not have bosses, performance bonuses or thousands of investors breathing down your neck every quarter. This gives retail investors an advantage and an ability to focus on the long-term, opposed to reacting (and usually trading) every quarter. This is also important when quoting all of the stats out there that show how much more effective passive investing is than active. Comparisons often focus on the performance of high cost funds and furthermore fund managers are surrounded by conflicts of interest. Retail investors don’t have to deal with these problems and can actually gain an edge because of this while not facing the drag on returns that fees often create.
Human nature – What if society simply looked at the moon and never bothered to actually step foot on it? Or what if Christopher Columbus never tried to find that water route, in turn stumbling across North America? What if Michael Jordan just didn’t feel like practicing? Humans by nature are always trying to improve, always trying to be better and there is no reason that this temptation to be your best would not carry over to investing. This is not necessarily a defense for active investing but it is another reason for it and can help with understanding why some investors still believe in it.
If an investor does not have the time, interest or patience for investing, then a passive indexed strategy is likely by far the best route. This route could also deliver solid market returns. But just because passive investing is a great option, does not mean that forms of active investing are not reasonable. The two approaches do not need to be mutually exclusive for investors – My Own Advsior’s approach listed here and here provides some evidence of that. While even at 5i Research (affiliate) we are proponents of ETF investing, we believe in balanced conversations about what active investing can mean, including avoiding conversations that shift the pendulum too far in either direction. Discussions and investing styles that focus solely on one viewpoint could limit investors from seeking out a journey that can be fulfilling, very rewarding financially and even fun.
Whether sports fans put their passions behind the Toronto Maple Leafs or Mark’s Ottawa Senators, it’s important to keep some perspective. Investing is all about perspective and making sure your approach is tailored to your financial goals and objectives using passive investing, some forms of active investing or otherwise.
I want to thank Ryan Modesto for this post, Managing Partner at 5i Research, a fan of My Own Advisor who offers quality conflict-free investment research to investors.