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The downside to passive investing.

In the last few weeks, a handful of people have asked to see a greater discussion of the drawbacks to passive investing. I’ve been thinking about it a lot. So here we go…

  1. It’s boring.
  2. There’s precisely zero chance that you’ll get rich overnight.
  3. It’s difficult. (Not the mechanics of it–those are quite simple. The hard part is sticking it out through a down market.)

From my perspective, that about covers it. :) Anybody have anything they want to add?

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Comments

  1. Miranda says:

    LOL. I, personally, think boring is a good thing. It’s better for my peace of mind. I can’t really think of anything else, either. And, if you are a boring investor like me, those three things aren’t really disadvantages. :)

  2. You might feel a lack of control.

    Sometimes playing the “lottery” can be fun!

    Some people enjoy the “game” (especially the highs of winning).

  3. As a (mostly) passive investor, I must say I agree. You can bypass the boring by doing something else with your life, get rich by improving your job situation, and recognize that no philosophy is worth following unless it’s sometimes challenged.

  4. I’d like to seem some discussion about the things that might impact average returns over the next 40 years. You have people like Warren Buffet, for example, that have stated flat-out that we’re crazy if we think that average returns over the next 100 years will be as good as average returns over the past 100 years. How should we oblivious investors digest that input? What effect, if any, should it have on our investments or other planning? Your readership is probably a conservative group, so I expect it will be a wide-spread concern: what are the chances of average returns not being enough for our retirement plans; how can we tell a) what the chances are, and b) whether it’s happening to us 5, 10, or 20 years down the road; and what can we do about it?

  5. Ethan: Sounds like a great idea for a post. I’ll work on putting that together.

  6. I’d like to add that although passive investing is good in may ways, the idea of just standing by and doing nothing during market debacles is mind boggling. What ‘rule’ requires you to accept an occasional massacre?

    I prefer passive investing, but with hedging. Why accept unlimited losses for no reason? Options can be used to insure the value of even passive portfolios. The true cost of that insurance is a limited upside. What’s wrong with that?

  7. Anybody have anything they want to add?

    How much time do you have?

    I’m just kidding around (kinda, sorta), Mike.

    My take is that you absolutely must take valuations into consideration when setting your stock allocation. That’s a biggie, in my view. But with that change and perhaps a few other adjustments around the edges, I think we would have a winner.

    Rob

  8. There we go–I was assuming Mark and Rob would eventually chime in, hehe. :)

  9. Joe Light says:

    I think a lot of investors are starting to agree with Rob. Buy and hold investing doesn’t have to mean “Buy stocks at any price and hold forever.” There’s also no rule that says earnings growth going forward has to be as robust as what it was in the last 30 years. One of my colleagues at work wrote a while back that expecting the U.S. to grow as fast as it has since WW2 is like expecting Microsoft to grow as fast going forward as it did between its founding and dominance of PCs.

  10. Passive investing, like active investing, will underperform at times. Every single investment strategy have its period of underperformance. This is a downside because some investors flip once they are confronted with the reality that nothing is perfect.

  11. Joe: I’d agree that we shouldn’t expect a rate of return (in the U.S. market) over the next 30 years equal to what we’ve seen from it in the last several decades.

    My answer to that would be that we should lower our expectations (and adjust other variables accordingly) rather than attempt to beat the market.

    Neal/Wealth Pilgrim: At times, passive investing will underperform what? :)

  12. Haha, love the list! This is one of the few cases where boring = awesome.

  13. It seems that those who stick to 100% passive investing don’t seem to want to learn how the market works. It’s great to have your finances automated and have the discipline to invest regularly, but most folks who use index funds don’t really bother reading up or studying how the market works.

    It’s like they’re just along for the ride. However, if you’re a passive passenger along for the (stock market) ride, what happens when you actually have to get out and drive?

  14. Reading these comments I believe that there is a huge misunderstanding about what investors characterize as “passive investing”. I believe that investors understanding is that you sit around and do absolutely nothing.

    Well this is really not a true definition of “passive investing”. There are two diametric belief systems about the market and the nature of markets. The first is that markets work (passive), the other is that markets do not work (active).

    The market works belief (passive) is what is known as the belief that the market is efficient and states that the markets are random and unpredictable and that they will quickly reflect new information and knowledge as it becomes availbale.

    The market fails belief (active) states that markets react slowly enough to allow some individuals to analyze and predict the future in order to take advantage of mispricings and pass value onto the investor.

    Because most investors have never even questioned the two differences or let alone read about them – they try to marry the two or make up their own definitions.

    Taking the passive approach to investing what you are doing is using Modern Portfolio Theory to build a portfolio that is globally diversified among various asset classes using index type funds or structured index funds to deliver market returns for the asset classes in the portfolio. The goal is to provide maximum diversification and correlation effects while maximizing returns for a given level of risk.

    It is also a life long process because you understand investments, the markets, and how they work. You do not market time. However, you do rebalance your portfolio in order to maintain your stated risk tolerance throughout the life of your portfolio.

    I hope this helps some of you.

    PS. Please don’t bash. I am only trying to give some insight.

  15. Matt SF: What exactly do you mean when you say, “if you’re a passive passenger along for the (stock market) ride, what happens when you actually have to get out and drive?”

    Richard: Excellent explanation. Thanks for stopping by to contribute. :)

  16. There are two diametric belief systems about the market and the nature of markets. The first is that markets work (passive), the other is that markets do not work (active).

    That’s a simple and accurate description of the primary point of contention.

    My view is that markets work when investors are educated about how they work and that the massive promotion of the Passive approach (as it was initially developed) has led to investors not being educated about how markets work. If most people understood how much the valuation level that applies on the day you purchase an index fund affects your long-term return on that fund, prices would self-regulate (once prices got too high, millions would sell and prices would return to reasonable levels).

    The problem in recent years is that the heavy promotion of Passive Investing concepts has led millions to believe that high prices are not dangerous. It’s that belief that caused prices to go to such insane levels and remain at those levels for so long.

    Rob

  17. Dave C. says:

    My stance is, combine value, contrarian, and passive investing all in one.
    If you buy a great company at a low enough price, you won’t need to bother with watching the ups and downs of the market. At least thats what Ben Graham seemed to be telling me in “The Intelligent Investor”.

  18. Brad Knotts says:

    Rob Benett posited: “the heavy promotion of Passive Investing concepts has led millions to believe that high prices are not dangerous. It’s that belief that caused prices to go to such insane levels and remain at those levels for so long.”

    Interesting hypothesis. Perhaps you could provide some evidence to support this contention? I have looked in vain using internet search engines for any evidence of correlation between the advocacy of ‘Passive Investing’ (whatever that may be defined as) and the high price of stocks. I see no such claim or indication anywhere, except by you.

    Thanks.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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