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Archive for April, 2010

The greatest risk to passive investing is being too active.

Passive investing is an investment strategy in which a portfolio is managed with as few trades as possible to minimize costs and taxes. Index funds are the most popular form of passive investing. Active investing seeks to outperform an index through the strategic buying and selling of securities.

Statistically, there can be little doubt that passive investing beats active investing. This is supported on an ongoing basis by SPIVA as well as numerous other academic studies. In my view, the biggest problem with passive investing is that many investors are emotionally unable to stay the course. In other words, there are certain investors who are not passive enough to be successful with passive investing.

For instance, many passive investors bailed out of equities during the 2008 decline, most right near the bottom. Many were still out of the markets in 2009 during the massive recovery, afraid to get back in. They locked in their losses and missed the rebound. This was not what they were supposed to do according to the passive mantra, but emotionally they could not stick with the plan.

My clients are constantly being swayed by the news and wondering if they should make changes to their portfolio. I spend time talking them out of making moves because of Greece or oil price movements — not to mention interest rates, China and maybe even rumours of the cancellation of 30 Rock.

A study entitled “Investor Timing and Fund Distribution Channels” shows that investors will often underperform the actively-managed mutual funds in which they find themselves. They make bad market timing decisions that have a negative impact on their portfolios. This is disconcerting, since the performance of actively-managed funds is already impaired by the higher fees.

It is easy to state that a simply constructed passive portfolio will outperform an active, higher cost portfolio. Without the help of investment professionals however, certain individual investors will most likely undermine the ideal that is passive investing and be worse off than if they had a good and honest investment counsellor. What kind of investors? My experience suggests both the novice investor and those with too much confidence in themselves will have difficulties with passive investing.

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