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.
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.