Behavioral Insights to the Passive vs. Active Debate

When I present at conferences on behavioral finance matters it is not uncommon to get a question about whether passive is better than active or vice versa. As with most investment decisions there are pros and cons – tradeoffs between the two. And what is right for investors may be somewhat subjective.

What is Not True

Behavioral finance academia prefers passive investments over active. That is largely because these PhD’s are still part of academia – they haven’t done what you and I do. While they are specialists in biases, they don’t have the experiential knowledge to understand exactly how powerful and unconscious biases are on investors.

For example, academia and many roboadvisor platforms assume that a passive investment strategy will help investors stay the course. I completely disagree. Not only does it not make psychological sense, but empirical evidence is on my side as well. Do you think investors, upon seeing their account value going down drastically and hearing apocalyptic forecasts, will stay the course because they are in an index fund? Heck no! And when we have had volatile markets in the past, roboadvisor platforms such as Betterment have crashed…because investors are logging in rather than ignoring the noise.

But this doesn’t mean active management is preferred. The type of management, active or passive, isn’t what investors think about when they are reacting to short-term market and economic outcomes. During volatile markets, the amygdala is firing messages and neurotransmitters that target feelings of fear – be it fear of loss or fear of missing out. We are constantly tempted to either “get to safety” or “back up the truck” irrespective of whether we own active or passive investments.

Pros and Cons to Each Style

Passive investments are lower cost, more tax efficient, and oftentimes more diversified than active investment styles. These are all benefits. In a year when you have the “Magnificent 7” driving the market returns, you know that a large cap index fund owns them all and is participating in all of those gains. The downside to a passive investment, in my opinion, would be lack of risk management. If these “Magnificent 7” went down a lot this year, as they did in 2022, it would be a whole different ballgame.

The biggest benefits of active funds is the potential to manage risk and not become too concentrated. Some active investments will market “high conviction” strategies – which sounds really good. But most of those investments underperform their passive counterpart on a pretty consistent basis. This is because market index performance has a history of being led by just a few stocks, and if those stocks are not included in the “high conviction,” the active investment doesn’t do too well.

Know Why You Own What You Own

From a behavioral perspective, the most important thing is that investors know why they own what they own and what to expect from it. Investors should know the pros/cons and how these investments may perform in various market scenarios. Then, when the market does what it does (volatility), investors will be less likely to bail from their strategy. I personally will use both active and passive funds in a portfolio, and I consider an investor’s risk profile when determining the split between the two.

The reality is that our goal is not to maximize portfolio return. It is to maximize investor return within their risk parameter and other constraints. Recommending an “outperforming” portfolio does nothing if the investor cannot stand the volatility and hold it for the long term. That is why the human element is so important in what we do. Unfortunately, industry risk profilers do a poor job of telling you about the behavioral makeup of the client.

That is why I developed, and many advisors implement, a behavioral bias questionnaire to supplement the risk profile. This gives a much greater scope of the investor’s psychology – which is what will ultimately influence their decisions. Advisors can then construct a portfolio with greater confidence that the portfolio matches their client’s complete profile. Passive and/or active investment strategies may be used, not because of cost alone, a sales presentation, or marketing support from a company. But because it gives the best odds of being the portfolio that client can stick with.

– JAY

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