Passive income is an investment approach that aims to match the return of a certain area of the capital markets. This is achieved through buying and holding all securities comprising the specific market. Indexing is the most common form of passive investing. It is a strategy to match a particular market index or benchmark, like the S&P 500.
Active investing, on the contrary, attempts to outperform the returns of the market through ongoing buying and selling of mispriced securities and scheduling purchases and sales based on the predicted market price movements.
Performance is the key reference point to determine which approach is superior because it is easier to understand.
Here is a list that proves the performance of passive investment is better than active investment:
Superior Long-Term Performance
According to a research into money manager performance, it can be noticed that over time, most active money managers do not succeed to beat their benchmark index. A small percentage of managers indeed outperform but it is very hard to identify them in advance. Moreover, research shows that there are low chances of them to outperform again.
Diversified portfolios hold various asset classes, including municipal and taxable bonds, real estate securities, and small company stocks from the US, international, and emerging markets. Since the possibility of the small number of managers outperforming again is low, the effort is unproductive. Passive investing accepts the average return of the market. Hence, it is a superior performing strategy.
Low Costs
Minimizing costs is essential if you want to achieve success in long-term investment. Unlike market performance, the cost is something that investors can control.
You must know that the money spent to pay for trading costs and management fees reduces returns directly. According to studies, the expense ratio of a fund is the most reliable predictor of its performance in the future. Low-cost funds appear to deliver above-average performance.
Passively managed funds usually have much lower transaction costs and fees compared to actively managed mutual funds because they do not trade very frequently and do not have to pay for expensive research.
Broad Diversification
Passive investing is a perfect strategy to attain broad diversification, which is a crucial element for long-term success. Passive funds usually use their target indexes to hold most of the securities. On the contrary, actively managed funds typically hold a much smaller selection of securities.
Tax Efficiency
Taxes are one of the biggest issues for long-term performance. The tax consequences of trading are not considered by most of the active mutual fund managers because they are judged on the pre-tax returns. The high annual turnover can result in higher tax liabilities.
Passively managed funds, however, trade a lot less frequently with their buy and hold philosophy. A low turnover results in the bulk of capital gains taxed at lower long-term rates, hence modest realization and distribution of the same.
Predictability
Financial planning is based on risks involved with different asset classes, their performance in combination, and modeling the returns. By using passive or index funds, investors can be more accurate in understanding the portfolio characteristics assumed by their plan.
Active fund managers can take on more or less risk than assumed, underperform their benchmarks, or drift from their stated style. Then, the returns can significantly deviate from those assumed by the plan. However, Passive and index funds are consistent and predictable in delivering returns of their underlying asset classes.
Applicability to Any Asset Class
While passive investing is commonly associated with large-cap indexes like the S&P 500, the strategy can be applied to any asset class easily. Passive and index funds are available for various capital market areas including conservative fixed-income and emerging markets small-cap stocks. Even less traditional portfolio components like real estate, inflation-protected bonds, and commodities can be indexed. Thus, these areas also benefit from passive investing.
Ease of Understanding
It can be overwhelming to evaluate proposals by different brokers and financial advisors. While research shows that only a few can beat the market, every sales presentation claims to offer a combination of market-beating strategies from top-notch managers. The research and portfolio construction process of active management often lack transparency and are complicated. Attempting to evaluate each different approach is only frustrating as even the salespeople themselves often do not know about all components in the diversified portfolios.
A passive approach, however, avoids unnecessary complexity. Instead, it provides a straightforward and understandable solution. As investors know what they own, they can make more informed decisions.
Fiduciary Responsibilities
Investors serving as trustees add obligations as fiduciaries. The Uniform Prudent Investor Act governs the investment activities of trustees of private trusts in most states. The act also monitors fiduciaries that are responsible for recruitment plans, endowments, and foundations.
The Uniform Prudent Investor Act obligates trustees to consider investment costs, taxes, and diversification carefully. A passive approach is often the default standard to meet these requirements.
Discipline in Implementation
Maintaining discipline, which means sticking to a long-term plan is very challenging for many investors. Average investors do not get the long-term market rate of return as they buy at the top and sell at the bottom constantly and move from unpopular funds to those that are in favor.
You should know that following trends and chasing prior performance is not an effective strategy. These value-destroying behaviors can be avoided with a disciplined approach like implementing a financial plan through passive funds.
Less Stress
Investing is stressful by nature. Since stocks are volatile, performance is also uncertain. Even with a long-term focus, results are available every active day of trading. Active management adds more tension. It is natural to be anxious if an investor has to constantly evaluate performance, buy and sell funds, hire and fire managers, and listen to explanations and excuses.
A passive approach does not eliminate all the stress of investing, but it definitely eliminates the portion that is unnecessary. It is always better to invest with less stress.
These are the reasons why it is better to employ a passive approach than active investment.
