Passive Investing vs Active Investing: Strategies For The Stock Investor

by Todd Smith on 2012-10-2916

For experienced and first time investors alike, the plethora of investment vehicles and options can be overwhelming. It seems that on a nearly daily basis, some new innovation with unlimited promise and appeal sprouts through the already crowded investment landscape. Like many things, however, it behooves us to keep our investment styles simple. Believe it or not, a simplified investment approach not only makes our lives easier and less harrowing, but also can drastically improve our results. How do you do this? Consider a passive investment style. In fact, did you know that you can beat the average investor’s returns with the simplest investment portfolio?

Passive Investing vs Active Investing: Strategies For The Stock Investor

On active investing. One of the more common debates on Wall Street and in academia has been over passive investing vs. active investing styles. An active investing style really boils down to stock market timing: seeking to pick stocks and other securities that will outperform or “beat the market”, or to find a money manager who can carry our portfolios and us to the land of unbounded financial success and freedom.

On passive investing. Passive investing, to noone’s surprise, is the opposite. This approach relies on no expensive research, no unnecessary and futile attempts to time the market, and no hair-pulling attempts to spot the next Microsoft or Google. Instead, you are buying an asset class (large cap, small cap, European, etc.) and getting, in essence, the returns of that given class. For example, an active stock investor may attempt to buy small cap stocks or mutual funds for their discount broker account in an attempt to secure the best possible return. A passive investor on the other hand would simply purchase a small cap equity index fund or an ETF.

passive investing vs active investing
Image from Planet Yang.

Is Passive Stock Investing The Superior Approach?

So, which approach is better? More often than not, a passive investment style remains superior for several reasons. Let’s check out a few studies:

1. Compare the past records of fund managers to the performance of the overall stock market.
There was a mutual fund study conducted by Gruber, Das, Hlavka and Elton that looked into the historical performance of the entire universe of mutual funds from 1965 to 1984, which only numbered around 143 stock mutual funds back then. These funds were then compared to their indexes and you can guess what the study discovered: the index funds outperformed their proprietary counterparts by 159 basis points on an annual basis. Apparently, this was the case for ALL funds. And if you’re after a newer study, there was one that a prominent university conducted which showed that over 1,800 funds from 1961 to 1993 also failed to do better than the total market (by almost 2% annually).

2. Take a look at records of investment newsletters.
Another study that spanned 17 years and reviewed the complete recommendations of 153 different newsletters showed that there is no significant evidence of superior stock-picking ability for that sample of newsletters. Some individual letters do have superior performance, but this does not occur more often than would be expected by chance.

3. What about the Forbes Mutual Fund Honor Roll?
The Forbes Mutual Fund Honor Roll has been recognized as a great way to discover top performing mutual funds. There’s a tradition here, with Forbes magazine picking out some of the best mutual funds for inclusion in their prestigious honor roll. But here’s the thing, there’s a study by John Bogle, one of the investment world’s top investors (and founder of Vanguard), that evaluated the Forbes Honor Roll over the period of 1974 to 1990.

The study has determined that the Honor Roll mutual funds and the average stock fund were tied in performance for this period.

And here’s what’s more telling: the study has also shown that when you consider commissions and fees, the funds in the Forbes Honor Roll significantly underperformed the general stock market in that time period. By how much? The Honor Roll mutual funds clocked in with cumulative returns of 439.7%, while the total stock market returned 633.4%, a huge discrepancy of 193.7%.

However long the debate continues, I often ask myself and others to be honest. If professional money managers rarely, if ever, can match or outperform the market consistently over the long-term, then why should we kid ourselves and think that we can do this by choosing the best manager or investment for our cherished portfolios? Let’s face it, we probably can’t outperform the markets this way, so we should probably just keep things simple.

Created May 25, 2010. Updated October 29, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.

{ 16 comments… read them below or add one }

Impulse Magazine May 25, 2010 at 7:52 pm

I think I would rather do passive investing because I am in it for the long term.

Jimmy May 25, 2010 at 10:44 pm

Great post…and yeah I do believe one can do just as well with a simple strategy, ETF’s are great for this too!

ConsumerMiser May 26, 2010 at 4:12 am

Love the article. I am a passive investor instead of an active investor. I am not trying to time the market or spending huge sums to do so. I am taking the inexpensive long term approach. Given your information here and the historical returns, I think I have made the right decision. You have confirmed my past conclusions. Even the pros don’t outperform the market over the long term.

James May 26, 2010 at 8:10 am

So are you trying to say that most stocks do not perform well and to stay away from the market as a whole?

My guess is that most stocks and companies fail, but if you can find a few that perform well you can make a significant amount of money in the market.

Rob Bennett May 26, 2010 at 9:14 am

“Passive” Investing works well so long as you are sure to dramatically lower your stock allocation when prices get to insanely dangerous levels (where they have been from most of the time-period from 1996 forward). Stocks obviously have never provided a good long-term return starting from these sorts of price levels. The people advocating “Passive” Investing often fail to mention that.

The real question is — What does it mean to be “passive”? I certainly agree that you can obtain great returns investing in indexes. Indexes are wonderful. But a lot of the people who advocate indexing fail to warn investors of investing in indexes when they are selling at high prices. Buying an index locks in the market return. If you buy an index at a poor price, you are locking in a poor long-term result. That’s not smart.


Silicon Valley Blogger May 26, 2010 at 9:59 am

Don’t know where you got the idea that the suggestion here is to “stay away from the market”. The idea is to be invested in the market through more diversified methods, preferably on auto pilot. It would be awesome if we can leave things on autopilot completely, but that’s not really wise either. Things change, conditions and situations change and 100% passive investing may be a risky proposition given the fact that things don’t remain stable/status quo indefinitely.

I am an advocate of monitored passive investing and investing via indexes, and it’s the best strategy for average investors, IMO. But I’ve also dabbled with market timing and active investing to some degree for the learning experience (and to see how well this sort of thing would work for me). Going strict buy and hold is no longer the best idea (given the effects of the latest crisis), so some hybrid approach (passive with a little active investing?) may seem more palatable these days.

Credit Girl May 26, 2010 at 12:57 pm

Great post! I personally don’t like passive investing because I feel kinda as if I am not really looking or caring for my investments. I could see how it’d be good for the long-run but I like to really get in there everyday and analyze my stocks so that I’m on top of my game.

Merv May 26, 2010 at 2:04 pm

A little over a year ago, before the market rebound, I checked the 10 year total returns on funds I’d bought over ten years ago and others that had at some time made it into a watch list, sometimes years ago. Of nearly 50 fund names so found, only two had negative 10 year total cumulative returns, the S&P 500 Index funds VFINX and FUSEX. The average fund manager is as impressive as the average pitcher if you include everyone who ever threw a baseball. The scouts for the big leagues don’t hire just anyone, and neither should you, but you might question even buying a mutual fund considering the way that they are taxed.

Mishera May 27, 2010 at 1:00 am

I’ve done my own research on investing for a while now and see plenty of points for both sides. Warren Buffet even said an index fund is adequate for most people. I still think a case could be made for active investing, and by active I mean the individual investor stock picking or timing the market. I’ve never been a fan of handing my money over to someone else to do something I could be capable of doing on my own. Plus funds have their own share of problems to overcome.

For those that argue funds as a active alternative run into the fact that they fall in a very different situation from an individual investor. Mutual fund have the problem of their size literally moving the prices of stocks and their limits on their holdings among many others. But it I think it’s the fact that they’re so competitive that allow for at least the occasional market timing. Anyone who put money in almost any big name company at the market bottom last year could have doubled their money by now.

Beyond that, stock picking may very well be possible, the only problem I see is at least in the short term the tax man could make it pointless. But at very least people can pick out few stocks than in the long run would beat the S&P 500. And I see active investing more so like gambling, looking for John Lynch’s the next “10 bagger” that you wouldn’t get investing in a index fund.

I guess it comes down to how much time one has or is willing to spend on investing. And it takes work. I’ve read a lot of books on the subject and feel that I haven’t even grazed the surface, not to mention the countless earnings reports and news articles. I’ll continue to use passive investing for my retirement account and try my hand at active in another one.

Chris Carosa May 27, 2010 at 6:57 am

Saw your blog got picked up by the Investment Company Institute daily news e-mail blast. There is an ongoing debate on active versus passive. From a practical standpoint, and echoing Merv’s comment, your readers might be interested in this article from Fiduciary News:

“Does the “Lost Decade” Signal the End of Passive Investing?” January 5, 2010

For readers attracted in economic theory (and who like Groucho Marx), this FiduciaryNews article might be fun:

“3 Reasons to Outlaw Index Investing Right Now (and One Selfish Reason Not To) in 5 Acts” May 12, 2010

Spotlight Investing May 28, 2010 at 11:23 am

@siliconvalleyblogger You can always consider combining the approaches at some level. By mainly allocating capital by asset allocation you can always choose to selectively pick active managed funds as part of the allocations, or actively investing yourself in those categories.

I don’t mean to imply you’re saying there is necessary linkage between a disciplined asset allocation investing style (theoretically most efficiently achieved through index funds and the like) and passive investing, but many people do.

DIY Investor May 31, 2010 at 10:11 am

For those in favor of active investing I recommend reading Lowenstein’s book “When Genius Failed”. It tells the story of how Long Term Capital Management, the biggest hedge fund in the U.S. with 2 Nobel Prize winning economists and quants from Salomon Brother’s risk arbitrage unit, came to the brink of bankruptcy as their much vaunted “value at risk” model failed.

Secondly read my post on Bill Miller of Legg Mason who beat the S&P 500 15 years in a row and then did horribly. He did so horribly that the firm is still feeling the aftershocks.

If you think you’re smarter than these people by all means go for it!

Moya June 1, 2010 at 9:00 am

I’m all for long term investing. I think that most people who trade stocks will ultimately lose out because they don’t really know what they’re doing.

Rising Returns October 29, 2012 at 8:13 pm

I prefer a mixture of the two. I like to make active decisions about what I buy and what I sell, however I tend to buy dividend stocks that provide me with a form of passive investing. After I’ve made my investments, I can site back and watch the money come in and reinvest on a monthly or quarterly basis. Of course, this come with the caveat that I’ve been very active and thorough in my research and have been smart about my decision making process.

Sam Das @ Wherewithal October 31, 2012 at 5:20 pm

Nice recap. While the passive vs active debate has strong proponents on either side, numbers don’t lie. S&P produces a bi-annual report called the S&P Indices Versus Active (SPIVA) scorecard report. It tracks the performance of actively managed mutual funds against their benchmarks. The results are pretty clear –
the majority of actively managed funds underperform their benchmarks on a consistent basis. Frankly, for new investors (who this article is really targeting) a passive strategy is easier to manage and get started.

Aram Durphy November 7, 2012 at 12:03 pm

What do some of the greatest investors of the 20th century have in common? Ben Graham, Warren Buffett, John Templeton, John Neff, David Dreman, and Marty Whitman would qualify as passive investors: buying when value is good, and waiting many years for the investment thesis to pay off. Smart investors can stand on the shoulders of giants, and emulate the long-term value process of investors with excellent track records of success.

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