Passive investing greatly outperforms active investing in the long run. Today we investigate why this is the case, by how much passive outperforms active and what steps you can take today to start investing passively.
Here at moneystepper.com, we are strong supporters of passive investing. Our simple recommendation for 99% of retail investors is to simply invest in a diversified range of low fee market ETFs. You may have heard this advice elsewhere, but still be wondering why passive investing is better than active investing? Hopefully, this article should provide you with all evidence you need to understand why passive outperforms active investing.
Today, I watched a great documentary by sensibleinvesting.tv which completely supports our views that passive investing is the better choice. Rather than making you read 3000 words of my research on the matter, it is probably quicker, and much more enjoyable for you to watch this documentary.
It’s incredibly well made and summarizes the many, many reasons why passive investing outperforms active investing:
The key points I took away from the documentary are as follows:
In a US study, out of 355 funds between 1970 and 2005, only 9 beat the index by over 2%
This is a very striking fact.
My first analysis would be that these 9 funds probably outperformed the index by more than 2% primarily due to luck. It is not unreasonable to hypothesize that chance alone would lead 9 out of 355 (2.5%) of funds to beat the market in this way.
However, let us assume otherwise and give the benefit of the doubt to these 9 funds. What if these 9 funds had beaten the market due to their skill? Well, we still face two problems:
- In 1970, how would we have known how to pick these 9 winners? How could we have known in 1970, that these active managers would have invested in the right companies throughout the boom years in the 90s? How we would have guessed which ones would have avoided the technology companies in the 2000 crash, or the financial institutions in 2008?
- What happens if an active manager leads? The performance of the funds can be largely attributed to the fund manager. Well, what happens if that manager leaves? Do we follow him or her away to their new fund? If so, will they have the same support and research team? Most of this is an unknown.
“The job of a stock broker is to extract the wealth of the client to themselves”
When looking at the costs of active investing, William Bernstein sums it up brilliantly. After stating the above, he continues:
“Typically they extract 2-3% of the assets per year from the clients and if you do this over a period of 20, 30 or 40 years, eventually your broker winds up with more of your assets than you do”.
This is the best summary I think I have ever heard of active investing.
Active fund managers make their money from you, not from the markets. Each year, only one return is guaranteed each year, and that is the fee that the brokers charge through management fees.
Let’s imagine that:
- our fund manager matched the performance of the FTSE 250 between 1st January 1986 and 31st December 2013
- we start with an initial investment in 1986 for £10,000 and then add another £2,500 at the start of every year
- our fund manager charges 2% management fees per year.
Our final value at the end of 2013 in this scenario would be £229,803. This seems like a great return, and each year only 2% in management fees may not seem like a lot when you are obtaining 13% per year returns.
However, when we look more closely at the results, we will note that in this scenario, we paid an incredible £50,889 in fees to the fund manager.
During the period, we invested £77,500 of our own money, meaning that we made a profit of £152,303.
This means that the management fees were almost exactly 1/3 of our final profits.
What is the alternative? We could invest in the Source FTSE 250 UCITS ETF. On this ETF, management fees are 0.25% per year.
If we re-run these figures, our fees would only be £8,055, and our final pot would be £329,529.
To summarize, we are nearly making an extra £100,000 in extra profits over this time frame by investing passively:
If this wasn’t bad enough, we need to revisit our assumption. We stated that our fund manager would equal the return provided by the FTSE 250 over this period. In fact, it is estimated that the average fund manager (let’s say we are lucky enough to find the average) has under-performed the index over this period by around 2%.
Add this in, and the fees we pay don’t change all that much, but our “final pot” in 2013 in the example above would be significantly less.
“You can’t predict share prices”
The summary of the documentary quotes a 1973 book by Burton Malkiel entitled “A random walk down wall street”. The conclusion he reached after a great deal of independent and unbiased research, his argument is as follows:
“You can’t predict share prices. If you can beat the market, it will be more than likely be down to luck. Even then, transaction costs will likely cancel out any extra returns you make. As for picking the next star fund manager, you might as well forget it. A blindfolded chimpanzee throwing darts at the stock pages could select stocks as well as the experts”.
The best thing about this quote is that it is true! A study was carried out where monkeys actually did throw darts at the stock pages. And guess what…they outperformed the fund managers who are charging you £50k in the example above to do so!
Who recommends active investing vs passive investing?
Practically the only people who consistently support active investing are the fund managers themselves. To me, this tells me everything I need to know.
This is like taking weight-loss advice from Ronald McDonald!!
Unfortunately, two equally good similes would be taking career advice from recruitment consultants or taking property advice from estate agents and mortgage brokers. However, this is as common as the above, and hence should probably form two separate articles in the future.
Finally, what man does everyone listen to for investment advice? Warren Buffett – the king of the stock pickers. Surely he would support active investing given that he picks what he considers to be the best companies in the world to invest in through his company Berkshire Hathaway? Wrong.
In his 1996 letter to shareholders, Buffett states: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees”.
Furthermore, in his 2014 letter to shareholders, he cements his argument:
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
Game, set and match to passive investing!
Passive investing is better than active investing
I hope we have now shown why we (and many, many others) believe that passive investing is better than active investing.
If nothing else, by adopting a passive approach to investing, you get to do something that you aren’t usually allowed to do in life. You get to be lazy. You get to be as lazy as the dog in the title picture!
So, join the increasing number of people who are simplifying and improving their portfolios:
Leave those fat cat fund managers behind, invest in a diversified portfolio of low-fee tracker funds and then just forget about it.
PS – if you enjoyed the documentary, the same producers are currently running a 10 part series (making up a full 80 minute documentary) entitled “How to win the loser’s game”, based on the same topic as above. I would highly recommend you check it out.
If you need any more advice on investing, please see our Investing category for many other articles like this.
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