Passive Investing: Best Thing Since Sliced Bread?

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Every personal finance blogger and authors have been expounding on the virtues of passive investing.

What is passive investing and why does everyone think it’s the bee’s knees?
More importantly – is it really right for you?

History of Passive Investing

Passive investing was pioneered and advocated for by the legendary Jack Bogle.  Jack Bogle was the founder and CEO of Vanguard Group, the provider of low-cost index funds.  He is credited with the creation of index funds.

Index funds are a type of mutual funds that aims to copy what is already in the market.  Most mutual funds are based on a professional money manager picking and choosing individual securities from inside that market.  Index funds just hold everything that the market has.

Passive funds don’t have to pay anyone to pick stocks nor does it need much monitoring except for the quarterly rebalancing.  Because of this, the cost to run the fund is much lower and the company passes on the savings on to the consumer.

Jack’s Thesis

In a brilliant analysis, Mr. Bogle did a thought experiment based upon what he knew to be true in the stock market.

The stock market is generally impacted by the very largest of players.  These are institutional investors like Pension funds, Insurance companies, and other investment shops. These players represent over 70% of the entire market.  This is generally true all over the world.

If this is true, then one institution’s gain was another’s loss.  But overall the market isn’t really impacted.  It’s transferring dollars from one pocket to another.  For each retail investors, Mr. Bogle knew to represent the tiny percentage of the market that was left over.  Retail investors have almost no impact on the market as a whole.

Instead of trying to pick the right institution to belong to, why not just let the institutions duke it out and suffer the losses?  For everyone else, just being in the market was enough because as the economy continues to grow, then the market will continue to go up.

Passive Investing is Born

Based on the conclusion of his thought experiment, Mr. Bogle created the first passive index fund.  While this might seem obvious to us now, it was quite the revolutionary idea in the 70’s!

It wasn’t a smooth ride to where we are now.  The idea didn’t catch on until recently.  Of course, the industry itself has been resistant to the idea. Investment firms make their money on the fee charged in the mutual fund.  Between the cost of the fund and the MER,  lays their profit.  If the fund company continuously improve their systems and reduce costs, they are banking that difference.

Passive Investing Fees

The most obvious benefit of passive investing are those fee reductions.  Most people don’t think about the fees much because they can’t see them.  The MER in all funds is priced into the fund.  Let’s say that the price of a mutual fund is $15/unit. That $15 already has the 2% fee hidden inside.  If it didn’t, then the true price is $15.30.

From a dollar perspective, most people upon seeing that might say, oh it’s so small – spare change. But that 30 cent fee is on every single unit. On $50,000, it’s $1,000.  Every. Single. Year.

So if you only ever invest $50,000 from the time you are 35 to 65, you would have missed out on $164,519! That’s 3 times your initial investment!

Here’s how I got to that number.  If we use the historic return of the stock market of 7% a year, compounded yearly for 30 years, your initial $50,000 would end up being worth $380,616.

But if you take 2% off the top of the return, you are only compounding at 5% yearly for 30 years.  At 65, your initial $50,000 will grow to $216,097.

That’s a difference of $164,519.

I won’t speak for you, but I sure can use that extra money.

Earning Active fees

Many investment fund companies would assert that their active stock picking is worth the 2% and over that 30 years, they would earn you more than the $164,519.  They will say that they protect you during down times when the market as a whole falls.

Sometimes that is true.

But if we go back to Mr. Bogle’s thought experiment, one institution’s gain is another institution’s loss. So in order for Investment firms to earn their fee, they have to be better than the market 100% of the time. But what is the likelihood that the investment manager that you pick, Fidelity, Edward Jones, Investors Group, will win every single year?

More likely, one year, Fidelity will do better, then Investors Group next year and then back to Fidelity and then Edward Jones.  As it happens, this is exactly what goes on with all of the investment firms out there. It’s found that in the US, a manager only has 1 in 10 chances of beating the overall market.

If that manager was one of the 10%, from there, it’s only a 33% chance they’ll beat it the next year too.

In a 2 year span, a manager has a 3.3% probability of beating the market.

I’m not one to gamble, but those don’t sound like very good odds to me.

Promise of Passive Investing

As we can see, for now, going the passive route makes a lot of sense from a lot of perspectives.  If we are just starting out or don’t want to spend the time doing hours and hours of research into a specific manager, then passive investing is beneficial.

Passive investing saves us time and it saves us from the fees that may or may not be worth it.  If a manager can show me they have beaten the market 5 years in a row, then I’d certainly consider them.  But until I find that unicorn, I can just use index funds.

Stay tuned to next week when we go over some of the potential problems that passive investing might pose.

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