Over the past several years, investors and experts have debated passive vs active investing. Passive investing refers to buying low cost index funds where stocks in the portfolio seldom change. Active investing refers to paying higher fees for a professional money manager to make tactical buys and sells of stocks in a portfolio.
I often get asked…which is better for an investor, active or passive? My answer is always the same. It really doesn’t matter that much because we are focused on the wrong thing. The return we earn through investing is more about whether we are an active or passive investor rather than using active or passive investments.
It’s a Behavior Thing
Depending upon the study, researchers have found that the behavior gap causes a portfolio drag of 1% to over 3% per year (on average). But averages tend to skew reality. Some investors have a plan and set a defense to help them make better decisions. Many have not. For those that have not, the drag on performance due to their decisions is much worse than the average. The average is skewed higher by those that behave well.
Take the last few weeks. We know that many investors sold during the small correction we had. For an investor who sold near the bottom of the correction, they are already trailing the markets (at the time of this writing) by over 6% due to the recovery, just from that one decision – and that assumes they get right back in now. The selling had nothing to do with choosing to invest in passive index funds or actively managed funds. The selling happened because these investors were active investors.
Change the Narrative
The only time the passive vs. active investment debate has any merit is when we are dealing with rational investors. And we know few people make rational decisions with money. It’s just not in our DNA to be emotionless when it comes to our money.
Rather than join the debate of active vs. passive investments, we ought to change our focus and discussion to the active vs. passive investor. The active investor is one that has an itchy finger, likes to trade and reacts to events. The passive investor is one who is confident, generally has a plan, and could care less about the news story of the day or how the market performs over a short period of time.
All else being equal, low cost investments always trump higher cost alternatives. But, all else is not equal. And investor behavior trumps all when it comes to the return on our investments.