Why Passive Management

Analysts in the financial industry are often highly educated, highly motivated, and they have faster computers and better resources than the individual investor could ever imagine. Unfortunately, hardly a single one of these analysts or fund managers is worth a dime. Why? The market is so competitive, it is nearly impossible to find investing opportunities that others have overlooked. In the words of academics, the stock and bond markets are “efficient.” That is another way of saying that all available information is already reflected in current prices, and future price movements are essentially random and unpredictable. In order for a fund manager to beat the market, they not only have to be smarter than the collective wisdom of the crowd, but they have to beat the market by enough to overcome the management fees they charge. Despite what many in the financial industry lead investors to believe, this is a very difficult task.

Institutional managers control over 90% of the money flowing through the markets on a daily basis. In short, they are the market. Therefore, theory would suggest that the average mutual fund returns should equal the market returns, before fees. And in fact, research has proven this to be the case. Once fees are accounted for, the majority of mutual funds cannot keep pace with the average market returns, otherwise known as the market indexes. Where actively managed mutual funds typically charge 1-1.5% annually, a reasonable index fund will charge less than 0.2%.

Over a 5 year period, you should expect roughly 2/3 of mutual funds to get beaten by their respective indexes after fees. However, this is far from the whole story. A well diversified portfolio for any investor should not be confined to a single mutual fund. In order to capture a broad array of asset classes around the world, 5, 10, or even 15 funds would be more common. As the number of funds increases, and as the time period gets longer, the probability that active management will beat passive index funds decreases ever further. Author Rick Ferri calculates that the probability of a portfolio of 10 actively managed funds outperforming a similar portfolio of index funds over a 20-year period is a meager 1%.

Passive investing is not fancy, and it will never make you fabulously wealthy in a short period of time. However, it will drastically decrease the chances that you will get beaten by the market and denied your fair share of returns. Perhaps more to the point, it decreases the chances that you will hit retirement without the capital you were counting on. If you choose active management, you may indeed strike it rich, but the odds are not in your favor.

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