Why is the foundation of a passive portfolio better than active?

Question

Over and over I see advice that passive portfolios generally do better than actively managed ones due to their low fees, and that, for the most part, portfolio managers can't beat the market.

Given this, there doesn't seem to be a solid reason why we shouldn't just do something like dump our money in a company like Wealthsimple and wait it out. However, lately I find myself concerned about the fundamentals of the U.S. as a nation state, and prefer the nimbleness of a portfolio that is dynamic.

That being said I'm curious to know why passive investing is considered the best choice? Is there a scenario where passive investing could become the riskier choice?

Answer 1

That being said I'm curious to know why passive investing is considered the best choice?

Because the market is inherently unpredictable and every attempt to predict it market will more often than not be wrong. This has been proven time and time again. Over 90% of all managed funds do worse than the S&P 500 despite the fund managers raking in billions of dollars in fees. With a few exceptions, the 10% who are actually doing better are just luck: given the large number of funds there's got to be some statistical variation.

If a highly paid professional fund manager can't beat the market: how can you?

Is there a scenario where passive investing could become the riskier choice?

The one lever which is still useful is to managing the balance stocks and less volatile investments. But that depends a lot on your details

Answer 2

You seem to believe that an active portfolio reduces risk because it can adapt to avoid "bad things" whereas a passive portfolio just blindly follows some arbitrary index and therefore would succumb to the "bad things".

But that assumes that the person making the decision can wisely make the right investing decisions to avoid the bad things, while not making bad choices that avoid "good things". History has shown that the people making those decisions do not make good enough decisions on average to overcome the cost of paying them to make those decisions. So while there may be cases where an active portfolio performs better, on average they do not perform better (after additional costs are considered) than a passive portfolio.

lately I find myself concerned about the fundamentals of the U.S. as a nation state

So then don't focus on US investments. Buy funds (active or passive) that focus on international companies, fixed income funds, etc. to reduce your exposure to the US market.

EDIT

After rereading your comments on other answers, I would add to my answer that active vs passive should not be a primary investment decision - meaning if you want to avoid the US market and active funds are your only choice, there's nothing wrong with using active funds.

In other words, it's better to use active funds in the segments that you want to investment in versus using passive funds that target markets you want to avoid.

Answer 3

I disagree with most of the other answers so far. It's absolutely possible to "beat the market" with an actively-managed portfolio, that's why an entire profession exists to do it. It's also why there are examples of such successful managers in history (example).

However, 1) it's really, really hard, and 2) the bigger you get, the harder it is to beat the market. It's why Buffett is on the record for saying he can make 50% returns a year on $1 million (but give him a much larger sum like $100 billion and that's no longer possible).

With that in mind:

Why is passive investing considered the best choice?

There are several reasons for this.

1. Because it's really, really hard to beat the market, people who can beat the market are in very high demand. That means they charge high fees, which means it cuts into your returns (you earn less, after fees). It's very possible that you actually earn less after fees from an active fund than you would have from a passive fund.
2. Besides, past performance is not a guarantee of future success. A fund can beat the market many decades in a row and then implode spectacularly. Humans are fallible, and if you are right over a long period of time, it's possible you come to believe that you are "always right", which is very dangerous (another example). This means any active investment is riskier: you are more likely to make more money, but there's also a nonzero chance of losing a lot.
3. On a personal level, when you manage actively you also make more trades. More trades means more commissions paid to the broker, so the bar you need to clear is already higher.
4. Finally, managing actively takes time and effort. Trawling through annual reports, watching Bloomberg TV, etc., becomes a necessity, not a luxury. Even if the individual trades are easy things that can be done in a few minutes, the thought process behind the trade is not. There is a reason why fund management is a full-time job. Are you willing to invest the time?

In short, assuming you don't want to invest the time (#4), and also assuming that you cannot risk losing most of your money (#2), then passive investing becomes the best choice. Otherwise active investing can be better.

Is there a scenario where passive investing could become the riskier choice?

Riskier than what? Passive investing is always going to be riskier than bonds (since the US economy going into a recession is significantly more probable than the US defaulting on its debts).

If on the other hand you're asking if passive investing could become riskier than active investing, then the answer is broadly "no". In general, the way to reduce risk is to diversify - that is, to invest in many different companies at the same time. Index investing provides automatic diversification, making it one of the least risky ways to invest. If you're investing actively, it's improbable you can stay up-to-date on hundreds of stocks at the same time, so you can't get as much diversification.

Answer 4

The foundation for passive investments is the knowledge that one cannot accurately predict the market. How many times have you watched the news, and they say something like "these conditions have shocked the experts". Those statements apply to everything from weather, to butter prices, to stock market activity.

In other words, the experts don't know along with everyone else.

So there is a case that can be made for passive investments that follow an index. Many indexes are dynamic, such as the S&P500 fund. Stocks are added and dropped a couple of times per year. A fund that follows such an index is dynamic.

Some actively managed funds are more dynamic, but they may be wrong.

we shouldn't just do something like dump our money in a company like Wealthsimple

This is something that I don't understand. Why is the new, sexy companies more attractive than those with a long track record. I would ask the opposite question:

Why would you invest with a company like Wealthsimple when companies like Fidelity and Vanguard are free for everyone to use?

Both Vanguard and Fidelity offer low cost index funds and ETFs. Both offer rebalancing services, research, free trades, seminars, and if you want a managed portfolio. Given their track record and size it is hard for companies such as Wealthsimple to compete.

For example, one can buy brokered certificate of deposits from either Vanguard or Fidelity. Say you have some money that you will not need for 6 months or so. You can stick it in your online savings account that might (currently) be paying 4%. Instead you could buy CDs with a few clicks paying 4.5%. Or if you are feeling like things will be okay in the short term, you could also buy junk bonds paying almost 6%.

So in my mind, checkout the Vanguard and Fidelity website and see which one you like the best.

Answer 5

However, lately I find myself concerned about the fundamentals of the U.S. as a nation state, and prefer the nimbleness of a portfolio that is dynamic.

Passive doesn't mean invested 100% in one market.

There are many indexes that can used. Some focus on a big broad market, others in a region of the world , and still others aren't even tracking stocks because they are 100% bonds.

You decide the mix of funds that makes sense for your situation, and you periodically make adjustments to the mix. You also periodically re-balance your investments.

The passive funds don't spend large sums of money doing research because they just follow the index. Over the decades the makeup of an index changes, and the funds follow along. The index funds don't feel a need to make trades just to show action, which also keeps their costs down, and is more tax efficient.

Answer 6

Running an "active" portfolio means that you, as a person, regularly invest your personal time into the topic, researching companies or markets, buying, selling, trying to beat the market and so on and forth.

"Passive" means you make a decision and stick with it long-term, say for at least a year, realistically longer. You'd only come back to investing when you do rote regular tasks, i.e. regularly moving money piling up in your bank account into your pre-determined stocks.

Deciding once that you want to invest 33% in a U.S. index, 33% in, say, Germany, and 33% in Japan; and then sticking with that decision "forever" is passive (as far as you as private investor are concerned), and still diversified.

The same goes for the people managing your fonds/ETFs - they only "once and for all" decide to follow index XYZ, and never go on a search for some better investment. They just regularly buy and sell according to the decisions imposed on them by their index.

Speaking of yourself as a private lay person; unless you are a finance buff, or treating this as a high-risk gambling hobby, experience shows that the you have very little chance to regularly beat the market with any degree of certainty. And for professionals, the same is true - but for them, we have survivorship bias, only ever seeing the very few who, by chance, somehow did beat the market. This is the reason why people say that doing this passively is "better" than actively.

Answer 7

Passive vs Active

Passive investing is considered best for most investors because markets are highly efficient. This means that information about the world is incorporated quickly into prices (sometimes in the order of microseconds), since market participants have a strong financial incentive to buy low and sell high. Your run-of-the-mill active fund manager is not going to be "nimble" enough to make investment decisions faster than high-frequency trading algorithms.

Market participants are trading to try to get an edge on each other, but in aggregate they will get the same market return passive investors get. Active investing means you'd be picking a fund manager with the hopes they can do better than half of the money invested in the market, most of which held by sophisticated institutional investors, by a large-enough margin to cover their high fees.

90% of funds don't outperform their benchmarks over 15-year timespans, and those that do rarely do it again in the next 15 years, so even that outperformance can be attributed to luck. That means your choice of active manager is essentially random, and you have less than 50% chance of outperforming. You can see then why getting a guaranteed "average" return (minus low fees) from a passive fund can be the best option.

US investments

You express concern about the fundamentals of the United States. But again, markets are efficient. Concerns about US institutions are already priced in to the market. Emerging market stocks, for example, will generally have lower price-to-earning ratios than developed market stocks, partly in response to their shakier legal protections. If new systemic issues with US financial markets come to light, the market will reflect that in prices very quickly.

So what? Maybe you disagree with the market. Well, that's a dangerous path for us small individual investors. The same way we can't pick which individual stocks will outperform better than chance, the same applies to countries. We work with limited information, emotions, and cognitive biases.

As a side note, it's worth noting that companies listed on US stock exchanges are not 100% reliant on doing business in the US. Most of them are multi-nationals selling globally, just like there are European-listed companies with US sales.

Rather than miss out on 63% of the global equity market, I would take my biases out of the equation and invest in countries in proportion to their market cap with a global equity fund like VT. In Canada, you might need to piece this together from multiple funds (and possibly consider possible the tax advantages of overweighting Canadian stocks), but using the same general principle.