The tragedy of passive investing is that it’s a strategy that’s long on evidence but short on influencers. While crypto interests can deploy crack squads of A-Listers to win hearts, minds, and wallets, there aren’t any global megastars promoting index funds and posting about their “passion for dollar cost averaging”.
Except for one. Warren Buffett, The Oracle of Omaha, the MechGodzilla of Masterful Insight, and one of the greatest investors and entrepreneurs of all-time… that Warren Buffett has been telling anyone who’ll listen to get into index funds and stay there, since 1993:
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
– Berkshire Hathaway shareholder letter 1993
And Buffett’s belief in the efficacy of passive investing has not wavered since:
In my view, for most people, the best thing to do is to own the S&P 500 index fund. People will try and sell you other things because there’s more money in it for them if they do.
– Berkshire Hathaway Annual Shareholder Meeting 2020, CNBC
In between times, Buffett’s candour on the challenges of investing, and his gentle pointers on how to resolve them, amount to the best and most authoritative guidance on managing your own portfolio that you’ll ever read.
Two countries separated by a common language: Buffett talks from a US perspective, hence he always mentions a US S&P 500 index fund as his tracker of choice. We recommend that UK investors think from a global perspective and go for a global tracker fund.
Why passive investing?
Here’s Buffett’s brief explanation that strikes at the heart of the passive vs active investing debate:
A lot of very smart people set out to do better than average in securities markets. Call them active investors. Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.
Therefore, the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
– Berkshire Hathaway shareholder letter 2016
Here’s the TL;DR version:
I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it’s just a matter of math.
– Berkshire Hathaway Annual Shareholder Meeting 2002, CNBC
Low costs make all the difference
It takes a huge leap of faith on the part of a new investor to believe that cheaper really is better.
Surely a field of human endeavour that attracts the brightest and the best can’t be dominated by ‘supermarket own-brand’ products such as index trackers?
Frankly, you couldn’t wish to hear the truth from a greater source of integrity than Buffett:
Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation.
Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.
A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
– Berkshire Hathaway shareholder letter 2016
Forget picking stock market winners and losers
Granted, it’s a blow to the ego – but Buffett also cautions you against backing your own smarts:
The goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.
– Berkshire Hathaway shareholder letter 2013
The ‘helpers’ Buffett mentions are the ranks of advisors, organisations, and journalists whose livelihoods depend on gulling you into thinking you can gain an edge:
Wall Street makes money on — one way or another — catching the crumbs that fall off a table of capitalism and an incredible economy that, you know, nobody could’ve ever dreamed of a couple hundred years ago.
But they don’t make money unless people do things (laughs) and if they get a piece of them.
And they make a lot more money when people are gambling than when they’re investing. It’s much better to have somebody that’s going to trade 20 times a day and get all excited about it, just like pulling the handle on a slot machine.
– Berkshire Hathaway Annual Shareholder Meeting 2022, CNBC
Many people confuse patient investing (doing everything to tip the odds in your favour over the long-run) with speculation (the impulse to get rich quick).
Buffet warns:
The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”)
The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs.
Following those rules, the ‘know-nothing’ investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.
Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.
– Berkshire Hathaway shareholder letter 2013
The remedy is simple:
So I would pick a broad index, but I wouldn’t toss a chunk in at any one time. I would do it over a period of time, because the very nature of index funds is that you are saying, I think America’s business is going to do well over a – reasonably well – over a long period of time, but I don’t know enough to pick the winners and I don’t know enough to pick the winning times.
– Berkshire Hathaway Annual Shareholder Meeting 2002, CNBC
Buffett on active management
It’s entirely natural to believe we can buy in an expert to solve our problems. Indeed, Buffett agrees that outperforming active managers exist.
It’s just the odds are stacked against you finding one of the few:
The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods.
If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet.
But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.
Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.
The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.
– Berkshire Hathaway shareholder letter 2016
Confidence trick
Buffett has a theory that helps explain why successful people often find it hard to heed his passive investing advice:
Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.
I believe, however, that none of the mega-rich individuals, institutions, or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.
That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment ‘styles’ or current economic trends make the shift appropriate.
The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.
In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial ‘elites’ – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.
This reluctance of the rich normally prevails even though the product at issue is – on an expectancy basis – clearly the best choice.
– Berkshire Hathaway shareholder letter 2016
This matters because the rest of society instinctively turns to the ultra-successful for its social cues. Buffett counsels against this course:
Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something ‘extra’ in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else.
The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.“
– Berkshire Hathaway shareholder letter 2016
Don’t panic!
Buffett is at his most reassuring when he reminds us that we can withstand future investing storms:
American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit, and an abundance of capital will see to that.
Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle. Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism.
Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.”
During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.
– Berkshire Hathaway shareholder letter 2016
One of the good guys
Buffett has long played the public role of an aging Good Wizard who reminds us that it’s not impossible for a fundamentally decent person to rise to the top.
(And also that not every multi-billionaire has to spend their fortune on sending steel cocks into space. But I digress.)
To return to Buffett’s less celebrated role as a passive investing guru, I have one final quote for you that provides the strategic bedrock upon which to build a successful investment strategy:
You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no.’
– Berkshire Hathaway shareholder letter 2013
Take it steady,
The Accumulator
Thanks for this excellent piece @TA.
Allison Schrager on Bloomberg recently covered Buffet’s preference for ‘passive’, but also his home market bias, with him sometimes recommending an S&P 500 tracker and some US Treasury Bonds: https://www.bloomberg.com/opinion/articles/2023-06-12/personal-finance-big-us-stocks-can-t-outperform-forever
Her most pertinent points, I thought, were to always bear in mind that returns are very sensitive to the period of time being considered and also to the very particular set of circumstances that applied to that period.
@Time Like Infinity — Jack Bogle had the same US home bias and recommended an S&P 500 tracker, from memory. I’m not sure it’s only home bias that drives their thinking; either way if you’re going to have it there are structural reasons why the US has long been the place where it’d be the least damaging. (i.e. Not just on the basis of recent higher returns).
Of course I’d suggest a global tracker is an intellectually more well-founded bet for American investors too, especially in light of valuation dispersion and the long period of late of out-performance. But one could credibly flip that and make a case for US over-weighting given its tech dominance. You pays your money, takes your choice, etc… 🙂
Great piece. Buffett has been so generous in the wisdom he’s imparted, especially given he can explain it in such easy soundbites. (Though one should also remember he does make mistakes!).
The comments above are a good reminder that there will always be an Active element to any Passive strategy, but it can be fairly minimal.
Personally I think I’d stick to the S&P500 as a) it’s furiously efficient b) very diverse c) for now the US seems so much more dynamic than Europe in terms of companies and ‘natural selection’. And for Asia, I think the indices are much more random & you CAN find Active managers who consistently outperform.
But of course, these things can change, so I’ll always keep an open mind.
tom_grlla #3
The Asian markets are likely less efficient, but it seems unlikely that you can identify the active managers with the skill to exploit it. But, if you know of any, I’d be interested to know who they are.
A timely reminder of Buffets passive wisdom. His books are inspirational for being a know-nothing investor purely for the simplicity of index funds with low fees. Set and forget. Come back years later when it’s near the time you want to draw it, the everyday valuation is pointless in between.
Andy D4
@tom_grlla: Worth noting that at times in recent years the MSCI ACWI has been >60% in US shares (the FTSE world index similarly), so if investors had chosen a Global tracker linked to the MSCI ACWI then they would have gotten a substantial position in the SP500 & Nasdaq, but also exposure to the out or under performance from both 22 non-US developed markets and 23 emerging markets (and to 2933 stocks v 500 in the S&P). (NB: albeit that they still wouldn’t have gotten any Small, Micro or Nano Caps or Frontier Market exposures, so this would fall a bit short of being genuinely ‘whole of available equity market’ coverage).
What I personally find puzzling is those investors outside the US who choose only to track their home equity market, esp. in the UK.
If you look at the S&P500 it’s not too hard, I’d suggest, to see 20 or more plausible candidates for disruptive companies that could form the future 4% of stocks which Hendrick Bessembinder’s well cited research suggests might be expected to account for all future excess equity returns over those which are available from one month Treasuries.
In contrast, when I look over at the list of stocks in the FTSE 350, I find it really hard to do the same.
Granted the UK is a fair bit cheaper, on most valuation metrics, than the US, and yes it is a bit weird that one US firm, Apple, is now being valued more or less the same as the whole of the FTSE 100 index constituents.
But what we’re interested in as investors is future returns, not present relative valuations per se. Current pricing is just one input into future performance. It’s obviously important, but not necessarily always the most important.
Besides, if an investor wanted to invest in a country specific equity market because it was relatively cheaper as against its peers (i.e. avoiding EMs for UK investors), then why not look at both Germany and Poland, whose home indices are really significantly cheaper, on those same metrics, than the FTSE 100?
I don’t invest in country specific indices myself, but whilst I can see the case for doing so for the US, I just can’t say the same for the FTSE 100.
I’ve been into trackers for years but am having difficulty understanding the charges for the plainest vanilla ishares on the FTSE 100. I note from my latest broker statement that as well as the 7bp TER (doesn’t that T mean total?) for ISF I am paying 13bp for “transaction charges”. Any idea what that is?
There are very low or even negative charges for most of the etf’s (and notably zero charge for S&P 500) I hold, but in the case of ISF and VMID I am left paying almost triple the TER, which had been one of the main reasons for choosing these funds. What gives?
@dave
The transaction charges reflect the internal costs of the fund ‘buying’ and ‘selling’ shares to mimic the index and the flow of funds going in and out. The calculations are using a standardised method that can be negative , the figures vary if a fund is growing / shrinking in size due to inflows/outflows. The transactions figures vary depending on the time period and it’s hard to compare different funds unless you compare them over multiple time periods.
The larger funds tend to be cheaper , a better method of comparing rival funds is to compare the tracking error over a few years, if you’re paying 7bps that’s pretty cheap.
Great article as always
I came to my “Road to Damascus” moment many years ago via Vanguard Diehards (now Vanguard Bogleheads) blog ( no equivalent financial U.K. blogs in those far off days) and reading John Bogles books
It’s done the job for me -now 77-so far!?
What a difference it made! Apart from the consistent performance I slept well at night -no more stomach acid and financial life became under control leaving all that extra time for other important things like family and travel
For amateur investors it’s definitely the right investment policy-for now
xxd09
Even as a fairly squeaky clean passive investor my experience has been that optimisation at the margin has not panned out. Factor investing, not panned out. Funnelling new money into undervalued markets, not panned out. REIT diversification, npo. To repurpose the insight of a Mr J. Stalin: simplicity has a quality of its own.
@ Dave – https://monevator.com/transaction-costs/
Like many I guess, twenty plus years ago and financially unaware, I believed the hype that “index” funds dropped with the market whereas the “Star Manager” would save the day. Index funds were never promoted or mentioned, there was nothing to read or follow up.
I believe another drawback is their simplicity “Surely something can’t be that good, and cheap too”. I just paid the 5% commission per Isa towards their Porsche.
@TLI. “What I personally find puzzling is those investors outside the US who choose only to track their home equity market, esp. in the UK. ”
Doesn’t that show a certain lack of logic? On one hand, you are puzzled about UK investors with home bias but somehow US investors with home bias are ok. Take out the survivorship bias and the SWR for the US investor with a 100% home bias drops from 4% to below 2.5%. Nobody knew 100 years ago that the US would be the winner and Argentina (say) the loser. if you are passive you believe nobody knows who the winner over the next decades will be.
This is my beef with the passive types. Nobody in the market can outperform so active is wrong. They then proceed to say bonds are too expensive, the GBP will depreciate forever, and the FTSE is terrible but the S&P is great. They talk EMH, CAPM and all those economic toy models whilst simultaneously being 100% equities on the back of historical returns that imply an equity premium that would not exist if these models worked.
This is not a criticism. Personally, I try to have at least five cognitive dissonances before breakfast! But in another thread you were telling me a 5-year forward on the S&P at 640 (spot 700) in Mar-2009 was basically 50:50 since nobody knew whether it would go up or down. Yet you are close to 100% in equities, see the S&P as the best index etc. I don’t see this as intellectually coherent.
I’d like to tip my hat to the UK branch of the Motley Fool who enlightened me to Index Trackers in their book The UK Investment Guide. I bought this almost thirty years ago and it changed my financial life literally overnight. Maybe they were regurgitating Buffet or Bogle, but they did it in an accessible, humourous and easy to understand style that didn’t intimidate or patronise. A bit like Monevator. I have to admit that I thought everyone would be into Index Trackers now given the evidence, but it just shows how such evidence can be wilfully suppressed by money and marketing. You’re right, what’s needed is some high profile celebrities banging the drum about this subject, although I suspect the bigger issue here is that the vast majority of the public just aren’t interested in finance regardless of who is talking about it.
In the whole Active vs Passive debate, what about inactive investors.
There are plenty of shareholders who are neither Active or Passive. Think granny with her BT and British Gas shares. Or company employees with company share schemes.
These people would get lumped in with Active (because they are not in Passive funds) but are not making reasoned decisions about whether their investment is “good”. They may have made this decision once but not regularly.
Can Active Funds make a profit against these people? Are there enough people holding enough value of shares to make a difference?
Given no thought about whether these shares are well held, I would expect them to do the worst compared to Passive Funds or Active Funds. Then Active Funds can make a profit against this set of market “participants”
There is also an interesting philosophical debate about what would happen if everyone was a passive investor.
What would drive share prices without this supply/demand for the underlying share from sellers and buyers?
If everyone was passive would it become a self fulfilling prophecy, and all companies would remain same current place in the market cap ranking? And effectively we’d have stasis and a pyramid scheme with prices driven by inflows to passive funds from new savers hopefully outweighing outflows from retirees?
I’m certainly not clever or informed enough to follow the logic through , but interested in the views on here.
@ZXSpectrum48k (#12): thanks for the feedback. I don’t personally follow the S&P 500 but rather presently have gone for 100% equities allocation with 85% (ISA & SIPP) in Global trackers (e.g. Vanguard Global All Cap Fund, L&G International Index Trust Class C, VWRL ETF, etc) and the 15% balance (GIA) being comprised of both:
a) a ragged, unthemed mix of discounted ITs (but with a tilt to PE via HVPE, and to growth via SMT, the latter brought solely because it looked on its knees pricewise at <£7); and,
b). a legacy (frankly really rather crappy) side HYP made up of equity income ETFs, which I'm running down with sales each year to fund the ISA (following reductions to the dividend tax allowance from £5k to £2k to £1k, and soon to just £500).
Although I don't advocate for, or try and argue that, the S&P 500 is the best index to track, I am open to the argument that it could be; i.e., I don't follow that approach, but I do see why it is plausible that it might turn out be correct, and therefore why other investors might want to follow it, even though I don't. That doesn't mean that I actually agree with that view. I just accept that it could be right.
I do think there is something to be said for broad spectrum diversification where possible, where cheap and when it can be kept both low maintenance and simple.
So, if your income is in £Stg, and your house is in the UK too, then maybe it makes sense not to overweight UK equities (as compared with their modest share of the Global Equity market). That doesn't mean though that I would argue for going overweight the US, although I can see why some might want to do so.
It's true that I do have some bias here against the UK's relative long-term prospects.
A resurgence economy (and a national renaissance in terms of the prospects for UK listed equities) does seem rather implausible to me in light of Brexit et al, but perhaps I'm missing the bigger picture & opportunity. I certainly could be. I don't know anything at all about where the UK will end up in the future, either in terms of the economics leaderboard or in terms of country by country returns. So my bias could be leading me astray.
I agree with your survivorship point. In 1800 the USA was a frontier market. In 1900 it was an EM. After 1945 it was the global hegemon. It 1989 it was going to be overtaken by Japan. By the 2010s it was back to dominating global equity market cap. Who knows where it could be in 2100, or even as soon as 2050? And it might have all turned out very differently, as you rightly point out. Argentina is a good example for you to cite here for a possible counterfactual. In 1900 it, rather than the US etc., looked to be the future. CaspianReport covers this quite nicely:
https://youtu.be/vu22RNjjrG0 )
I don't claim intellectual coherence.
I find EMH somewhat plausible in its weaker formulation, i.e. the price is not right per se, but it is more likely that it is less wrong than the average person's assessment of what the price should be. As you identified in the other thread (re options opportunities), occasions can arise where EMH must be wrong. No idea in the markets works all the time, and both EMH and 'passive' investing are no exceptions.
So I am incoherent in that I do not believe that there is an overarching framework, logic or set of answers which always works (or which always even makes sense) in all cases; and which should, therefore, be defended regardless of changing evidence, arguments and circumstances.
All models are wrong, but some are quite useful; and too much rigidity in thinking can be dangerous.
So, I'm aiming for strong convictions, but lightly held. Isaiah Berlin's foxes, rather than his hedgehogs.
@Dazzle — Yes, these people are still active investors — as they hold a position that’s different from the market – even if they are indolent (strategically or otherwise! 🙂 )
Ignoring a few edge cases, active investing is a zero sum game:
https://monevator.com/is-active-investing-a-zero-sum-game/
So these indolent-active investors may win or lose versus more determined active investors, depending on their positioning.
They do have the big ongoing advantage of typically very low costs, at least.
Some LTBH of a few individual shares will do very well (the rags-to-FTSE-100 company share scheme millionaire types) but as most individual equities lag the market return, it’s unlikely to be an overall winning strategy.
Cognitive dissonance is the medium in which I swim. That’s why I need other humans to point out the error of my ways.
@ Dazzle – interesting question. I’d assume someone who just held some random shares but didn’t trade would be passive. For example, I’d be passive if I just bought and held a Danish equities tracker even though I couldn’t claim to ‘own the market’ from a global perspective. Same would be true if I just held British Gas but only ever collected the divis. Perhaps I’d hold the market to the extent that British Gas was correlated to it. No offence to Denmark, btw. Bloody love the place.
@ Jim McG – I wonder if I was starting now whether I’d even find my way to index trackers. There are so many countervailing pitches for my money. As a noob in any field, it’s so hard to know who to trust and who’s telling you porkies. I think the porkie-peddlers are getting more not less sophisticated.
Quick follow up: I find TI’s argument more convincing than mine but it must depend on how you define ‘the market’ and the extent to which your holding is correlated with it. I wouldn’t claim that an investor who simply held the S&P 500 wasn’t passive. Yet they’re not even holding the entire US market, never mind the world.
@TLI. I’m not in any way having a dig at you. Take Buffett recommending 90% US equities and 10% US bonds. That is hardly a passive asset allocation. It’s a huge active risk skew to ignore every market and asset class except equities and bonds (and tbh really he’s just in one asset class when it’s 90%/10%). He also ignores every country in the world except one.
To me, the passive portfolio is the one that achieves my objectives (in my case hedging forward liabiltities and providing future inheritances) with minimum risk of failure, and which takes no view on markets. The Buffett portfolio totally fails that objective on both fronts. It takes vastly more risk than necessary, so increases the probability of failure, and also takes a very clear view on markets and asset classes: that only US equities continues to win big. For me, it’s a massive deviation from my passive portfolio.
Call me crazy but right now I’m struggling to not go all in QQQ for my SIPP. I have faith in tech and I believe it should do well over 30 years.
Yes, it’s definitely a fair point and chimes too with @ZX’s musings. To an extent we might always say “compared to what” when defining passive vs active, but of course that’s a very clumsy way to go about communicating.
On the cognitive dissonance front, I never liked the ‘passive’ terminology anyway (compared to ‘investing in index tracker funds’) and always considered a blue chip portfolio of 20 funds held until death ‘passive’, for instance. So I’m arguing here from the perspective of ‘passive’ as I understand it to be used on this site. (Which makes @TA’s counterpoint perspective interesting 😉 ).
Ultimately I have a lot of sympathy with the view that pretty much everything is some kind of active stance in practice. But again, it becomes very clumsy as a way to communicate broad ideas, so we must reduce.
@ TI – agreed. Would have been better if ‘index investing’ had caught on as the term but then, passive investing sounds so much more doable 🙂
Another interpretation of the term ‘passive’ in this context could be the amount of effort it takes to execute. From that perspective, Buffet’s approach is arguably correctly named. ZXs being less so in terms of knowledge, experience, hassle, mathematical ability, accessibility and so on and so forth? I can’t argue with the logic of their approach, but at the same time I know I can’t implement it. So I’m left with a small and simple basket of index funds..
To me “passive” implies a bit of the hold and do not tinker element as well as the choice of investments. So as I’m fundamentally lazy and can rationalise away downturns (to an extent) if its only a paper loss it suits me quite well. Obviously to hold on you need to have some confidence that the investment is broad enough to have chance of bouncing back vs say a single stock or even an IT that falls out of fashion.
Of course there is no such thing as purely passive unless you own every instrument in the world and even then allocation would be an active decision.
@Rhino. Hmm. So I hold Bluecrest for over 20 years, Citadel Wellington and Millennium for over 15 years, and I’m an active investor because they are hedge funds. Someone who buys and sells an S&P500 ETF on an intraday basis is a passive investor because it’s a tracker fund. I don’t see the logic. Based on some FIRE blogs if I buy an annuity it must be an active investment since it’s not a tracker!
I think Warren Buffets Portfolio recommendation of 90% S&P 500 and 10% US short term Treasuries was for his wife after his decease
He thought the legatees should handle her inheritance in this manner
She had no interest in investing and would no doubt be in receipt of a very large amount of money!
xxd09
Sorry, I should have made my assumptions clearer (and they may well be wrong). I *think* you may own a few properties other than your primary residence and execute some funky trades based on market. conditions using analysis and instruments I don’t understand, you possibly have access to data I don’t and can purchase some products only available to finance professionals that I can’t. That’s what I’m alluding to with an alternative interpretation of the terms passive and active. I’m saying, if my assumptions are correct, your portfolio requires more brains and effort (and capital w.r.t additional property) than just buying VGLS60! In other words, I’m suggesting using passive as synonym for easy/lazy/low effort. But that said, it would be fascinating to see an article that outlined if it were possible to do your future liability hedging approach for an average retail investor? Say using those funds you mention? Almost like a ZX portfolio for dummies type post . Just a thought..
@TA (#10): I share the pain of nothing seeming to work in terms of sustained outperformance when compared to a one fund/ETF whole of the market global equity tracker portfolio.
Years back I flirted with value, quality, size and liquidity tilts (alongside a dash of commodities and gold), before settling on going for overwhelmingly whole of the market B&H.
I did also previously try momentum, and that did seen to work (unlike every other active tilt) but, upon reflection, whilst it gave some outperformance, it was the watered down, mass market ETF version of momentum (i e., top tercile, quartile, quintile or decile; so still 100s of holdings), with the default academic research based 12-1 month formation period; whereas it looks like the spectacular results for momentum in practice are more likely to be associated with the much higher risk and also very much higher maintenance ‘DIY’ methods, like either 3/3 months or 6/6 months formation (look back) / holding periods, very high concentration (5-10 holdings), and using basic trend following of some sort (e.g. 200 day SMA + VIX being under (risk on) or over (risk off) 20 etc.)
Once your doing that though then your trading IMO rather than investing, which is basically incompatible both with having a job to attend to and having a life to live (e.g. the strategy forces you to decide if you shut it down & go to cash whilst you’re on holiday, or instead to try to trade on an app whilst up a mountain with no network access and with your better half shouting at you that your ruining the holiday).
I’d argue though that it’s still: systematic (rules based); systemically grounded (i.e. with faintly plausible causal explanations in terms of markets over and/or under reacting, and with the presence of some structural difficulties stopping momentum being arbitraged away); persistent (across different asset classes & market regimes, and over long periods of time); and evidence led (well, at least it was claimed to have produced some good Sharpe ratios in the original backtest, and then hopefully also in the out of sample. The possibility of overfitting and p-hacking results is obviously a huge risk and an ever present problem with these DIY strategies). But, that notwithstanding, if your doing momentum in a super active, super concentrated way like that then it’s become just a form of trading now.
That for me really counts against it, and in favour of plain vanilla tracking instead.
In this regard, for me inactivity is the one of the three pillars of advantage to ‘passive’ whole of the available equity market tracking Buy and Hold, namely:
– Simplicity and lack of effort required.
– Assurance that, as you own the market, somewhere in there you will own a small share of each of the small number of winners (although this might be an argument for equal weight over cap weighted tracking)
– Lower fees.
All three are important, but for my own set of preferences I would rate lower fees as the least important of that trio although to be clear it is still important to me as returns are speculative, whereas costs are certain and costs compound.
I should have mentioned, I recall I also tried a low vol tilt, and that too failed to show any outperformance on a tracker.
Great article. I agree that passive investing is short on celebrity endorsement, but what a celebrity! There was Bogle of course, but he could always be accused of talking his own book. Buffett on the other hand, far from it. A phenomenally successful active investor, saying that almost everyone should invest in an S&P 500 index fund. And he really does mean almost everyone, including large pension and endowment funds. Forget foreign shares, factors, smaller caps, REITs, trading/market timing strategies, etc. Ignore pundits, consultants and definitely don’t hand your money over to an active fund manager. To emphasize again, he is saying this as an ACTIVE investor. When pushed, he does say buy treasuries as well, but does not want to dilute the core message.
It is hard advice to follow though as the financial services industry really does not want people to do that and go out of their way to overcomplicate investing and tempt us away from sensible, low cost investing. It is even harder these days with social media and people making outrageous, unverifiable claims with virtually no regulation. Sadly, it is part of human nature for most people to believe in magic. Still, we need some people to ignore Buffett to keep markets relatively efficient and liquid.
For your equity investments, trickle money into an S&P 500 index fund – that’s it. Wish I had listened to him!
He does not seem to get mentioned very often, but the person who got me into index trackers was Charles D. Ellis and his book “Winning the Loser’s Game”. I seem to remember that a new edition was being reviewed on the personal finance pages of The Independent and an online financial bookseller was offering it at a discount (this was before Amazon was dominating the market).
Should @TA & @TI do an online poll on replacing the phrase “passive investing” with something more accurate and usefully descriptive (like index-tracking buy and hold, or “ITBH”?)
Buffett’s right, of course. But try persuading a pension trustee board to go all in on passive index funds, against the might of the investment advisors and consultants. Good luck!
Buffett seems to have a strong bias in favour of what has worked for him i.e. investment in US equities. Plus Buffett doesn’t need to care about sequence of return risk.
Personally, I think being 90% in S&P and 10% in US Treasuries is way too concentrated, whether you are a US investor or not. I want far more diversification and lower risk. I’m glad I didn’t take his advice since my returns since 1999 would have been pretty rubbish. A few percent lower ever year adds up to a much lower net worth. Plus I would be even greyer with all the stress from those equity collapses.
@TLI Re: a poll, I don’t think that has legs. 🙂 As I said earlier, I don’t love the ‘passive’ terminology but it is the terminology we are now stuck with I think.
If someone buys and holds an active fund and doesn’t look at it for years, then the investment world considers that an active investment, because it is (in itself) positioned differently to the market.
An even greyer shade is someone who holds a broad portfolio of index-tracking country/region level ETFS, allocated differently to the global index and occasionally tinkered with to suit their views or strategy. We can see they are investing actively versus the purer Boglehead sense. But their strategy (provided the tinkering wasn’t too frequent or egregious) could easily fit into a book on ‘passive’ investing.
Then as has been said we have the ‘obviously’ passive investing, in theory and as promoted by Uncle Warren, in just an S&P 500 index fund, that is decidedly active when considered versus the global equity market (not to mention the vast array of other asset classes out there).
Finally, again, it’s not lost on me that every real-world portfolio is through a certain lens active (or that a big collection of active equity funds, say, might basically replicate a particular market, albeit at higher cost, and so be a closet index tracker).
So none of it is perfect – nor compellingly logical I’d agree – but it is what has evolved.
Changing our terminology on this site would just produce even more confusion I think, both internally and by getting out of step with the wider commentary.
The best we can probably do is be humble and try to dial down the dogma when defending our particular bit of investing ‘turf’, versus what was seen in the old active/passive wars of a decade or so ago.
To the extent one was debating strategies, such clashes were helpful. But where participants were really just debating labels it was less productive.
As Morgan Housel has said many times, a lot of investing debate is just people with different goals and aims — and here even language — talking past each other. (Definitely guilty as charged in my time! 🙂 )
@TI, I agree that we are stuck with the terms Active/Passive, but perhaps it would help not to think in binary terms. Saying the only risk assets I am going to hold are S&P 500 index funds means assigning zero weight to all other asset classes. Surely a major decision, I would call that a major active decision.
There are always other decisions to be made as well. How to rebalance, how to change the asset allocation as we age and/or circumstances change, how much to split between pensions, ISAs and unsheltered accounts. If, when and how much to annuitise. Again, a lot of these I would call active decisions.
IMHO it is best to recognise that many investment decisions we make are active decisions and not get too hung about it. Just try the best we can to make good thought through choices that are the right ones for our particular circumstances and based as much as possible on evidence.
Apart from learning about Index trackers via The Motley Fool, the other lesson they hammered home was about Compound Interest. I still underestimate, or totally forget, about the impact of this on my investing over time. Oh, and Pound Cost Averaging. I think I’d choose these three things as the pillars of an investment strategy, keep it simple, do it regularly and continue for a long time.
I will quickly add my vote in favour of “index-investing” being a better term for using trackers (since I think that the terms “active” and “passive” make much more sense as descriptions of the amount of activity involved in an investment approach) then move on since this change clearly isn’t going to happen.
Moving on to a comment more central to the current discussion, I think there is far too much black and white thinking, and far too much searching for intellectual purity in the “how passive is passive” debate.
My aim is to come up with an investing approach that is simple, requires little effort to apply, and gives me a good chance of achieving my goals. I really couldn’t care less what labels anyone else would apply to my approach, or whether anyone else thinks that it is sufficiently close to a pure market-based approach or not.
Another Dave.
According to Int Inv., the top ten most popular funds for March/April/May 2023 were: March Index 90%/April Index 80%/May Index 80%.
Perhaps the message is getting through. It would be interesting to know the % difference between the new and enlightened investors.
@TA The Nasdaq has blown most things out of the water over the last 10 years and has done very well this year despite everything! I don’t have an issue with the risk/concentration side – at least not right now, but I’m not all-in either. The US is very hard to bet against and continues to be so imop despite the threat say of the orange autocrat.
My experience of thematic tech ETFs is underwhelming too though – except for the semiconductors index eg. Soxx.
@ Calculus – Very interesting to hear about your tech ETF experience.
I almost decided to make tech part of my initial asset allocation when I first starting investing. I would have bought in via EQQQ – the Nasdaq tracking ETF. Facebook was powering up, the iPhone was barely off the launchpad and tech looked like the future. Yet I kept reading commentary that the sector was hugely overvalued. Ultimately, I decided it was an active bet, I had plenty of US equity, and I was clueless about the future, so I shied away.
I wrote a retrospective covering 10-years worth of returns for the sectors/themes I considered (e.g. healthcare, clean energy, gold miners, timber, infrastructure…)
It was an absolute crapshoot.
The longer I invest, the more attractive simplicity looks.
https://monevator.com/tag/10-year-retrospective:-2009-to-2019/
https://monevator.com/10-year-retrospective-investing-in-the-future-with-specialist-funds/
@TA Thanks for the links- ETF Crapshoot, yes although Id argue there’s more fundamentals at play in the Nasdaq itself – a broader range of companies selected for high growth and returns on capital (mostly by the low friction/high margin sales channels – software, pharma, semiconductors, internet). With the higher multiple valuations comes the over/under pricing volatility (and risk of a crash) which isn’t for the faint hearted, but the time averaged price should trend higher providing these companies keep delivering or the index maintains the ones that do.
That’s reminded me of a longer study on sector outcomes. This is worth a read for anyone interested in particular industries or investing themes:
https://monevator.com/sectors-themes-megatrends/
@Calculus. The Nasdaq might have blown everything out of the water in the last 10 years but it was a bloody rough ride in the prior 10. When I decided to set up my passive portfolio (passive not in the sense of Monevator, but in the sense of a long-term hedge for my liabilities) at the end of 1999, I decided I needed an overweight skew toward tech. I felt that tech was the one thing that could make me obsolete and destroy my income stream.
I bought a Nasdaq tracker as a proxy in Jan 2000. Went up from 7000 to 8400 in three months … nice. Except by Sep 2002 it was at 2000 and I was down 70%. I got about half my money back by 2008 then the GFC dropped it to 2000 again. It was 2016 before those first tracker units were finally onside.
Yes, those were small buys and later buys were bigger at better levels so it’s all worked out ok (ish!). But equities are still pretty much the worse returning product in my portfolio on a unitized basis. Moreover, 16 years is now too long for me to wait for something to make a positive return. It’s not the sort of sequence risk I can accept in big size.
@Calculus, @TA & @ZXSpectrum48k (#43-45): one has 1st to decide what to try and achieve; then the best way(s) to try and achieve it (in the circumstances, with what’s available); what it’s likely to cost (inc. emotional & opportunity costs) to try and achieve it; if one wants to pay that price; and, if so, to then go ahead, aware both of that price and of the risks to success.
An active sector or country bet is fine, but there is likely to be more volatility, bigger and longer drawdowns, and more sequence of return risk as an unavoidable price for the possibility of higher returns.
Nothing whatsoever wrong with that; but you can only manage risks, control your personal reactions to risks and set backs, and to try and transform one set of risks into others.
There is no solution which can eliminate either the risks themselves or the ‘price’ which is associated with a given strategy.
All of this applies to B&H global market index tracking, which of course has its own price and its own set of risks; including the often neglected risk, for some subset of personality types, of regretting, after the event, not having taken more risk.
I should add that risk here includes hidden risks, both those unknown or unknowable, and those which are knowable but not obvious or clear cut, for examples;
1 Being right but for the wrong reasons.
2. Being right but too early or too late,
3. Being right in some sense, but the market disagrees.
The classic example of this last one is the so called bubble. You can be right to call out seemingly excessive valuations, but the market just keeps going up, with you on the sidelines. High valuation may carry more risk, but this is in the eye of the beholder, and no valuation metric is privileged. Ben Carlson covered this recently at: https://awealthofcommonsense.com/2023/06/how-cheap-or-expensive-is-the-stock-market-right-now/
@ZX. TLI. I took some 70% losses too in the euphoria of 2000, and was working in a smaller Nasdaq listed co. at the time. Watching stock options grow 20x and fall back down to earth in a few months was another ‘learning’ experience, that taught me something about averaging out of a win and not waiting for the sky, and that yes stock valuations can be subject to all lot of outside variables. My sense is that its not the same for the index today, these are mostly established companies that have come through the stress test of the last year or two. But not to say a bubble won’t happen again, its probably a matter of when.
I do intend to modulate risk level as my attitude changes with age or if the market appears over-heated, subjective I know. Would like to learn more about other vehicles, such as macro funds, although it seems not so many available to retail investors.
Hi there
Would a Tech Index world fund pass for this passive approach? What if I put all my eggs into a wider basket of tech sector shares through a global passive index fund, which generally outperforms the S&P 500, does this count?
@Simon — You’re taking an active stance if you do that. The idea behind passive index investing is that you accept you know no better than the market as to which companies will do the best in the future (and which the market values accordingly). So you buy the broadest diversification you can as a ‘snapshot’ of the market’s views on all companies listed.
With all your eggs in a tech index tracker, you’re betting that an index of tech companies will do better than the market generally — i.e. that you “know better”. And/or, more mildly, that you’re prepared to put up with extra risk (volatility) on the path to outperforming.
I’m not saying that’s right or wrong (I am an active investor myself) but that’s what this investment strategy would entail. It’s not passive in the sense the term is used by the financial services industry. 🙂
@ZX, TLI, TA. I’m not one for detailed spreadsheets but to put some colour on it I made some annual return calcs on my SIPP portfolio which has run with variable tech equity bias and safer assets – doing some simple back outs of annual contributions which are low relative to the total. Average annualised return is a shade under 9% over the last 8 years including fees, which was when the active interest began. I’d be surprised to get that for the next 8!
This is the way! Even though all the evidence supports passive index investing as the way to go, there are still plenty of people out there who think they can pick winning stocks and outperform the market. I’ve stopped arguing with the friends who do this. It’s much easier to just say, “Good luck!” and wish them the best.
I’ll second that one @Jon Sterling #52. Index tracking variants take all three of the top slots in this run down today:
https://ritholtz.com/2023/07/how-to-get-rich-in-the-markets/
Time Like Infinity
That’s a great article, thanks for sharing!
Having re-read this, and Jack Bogles book, I have to say that as a UK investor, that Buffett and Bogles’ advice still adhered to buying an ‘S&P 500’ index fund, and not an all-world fund. At best, Bogle advices no more than 20% in international stocks, not 40% like Vanguard seem to advice. So, unless I am missing the point, could someone please tell me why the onus is on international, rather than following the simple ad vice given?
Buffett & Bogel may well be right on US investors sticking to the home market, which is amongst highest performing of any market globally since 1802, when Wharton Prof. Jeremy Siegel’s data for “Stocks for the Long Run” begins: a ~6.5% real return p.a. (dividends reinvested). For comparison, Credit Suisse’s Global Investment Returns Yearbook & Barclays’ Equity Gilts Study place global equities’ real return (income reinvested) at ~5% p.a. since 1900. A difference of 1.5% p.a. over 2 centuries really compounds. But upto 1914 US was in effect an emerging market. Only from 1942-5 did it become the global hegemon. Will the US and it’s market still dominate in 2100? In 1982 Ridley Scott’s “Blade Runner” showed a world turning Japanese by 2019, and in 1990 the Tokyo stock market cap dwarfed all others (a 60% share of the global total, similar to US now). Look at how that’s actually turned out since. If you believe that the US has permanent, unassailable advantages then the US is the place to be and stay in. But if you don’t then you have to go global and hedge your bets in every direction.
Even the most promising prospects fail. In 1900, Argentina was predicted to become South America’s superpower. Didn’t work out. Nobody, after all, knows anything for sure about the future. Heck, go way back into antiquity and it once even looked like Ukraine would be a world power:
https://unchartedterritories.tomaspueyo.com/p/why-isnt-ukraine-a-global-superpower
@Times Like Infinity.
That’s a nice history lesson, thank you, (I don’t mean that in a patronizing tone either). So in Buffett and Bogles thinking, if the US as a home market only is good enough for US investors, why is it not good enough for say a UK investor? Am I just splitting hairs here?
[A big thank you to @TI for looking into my post #56 initially not appearing. I’m very much obliged.]
@Simon Hinchley #57: Your not splitting hairs at all. Buffett & Bogel may well be right. It’s perfectly plausible that the US continues to outperform. Whilst trees don’t grow to the sky, some companies have done so. A disproportionate number of them have been American, especially over the past 30 years. On that basis alone, it’s completely fair and understandable to question the benefits of international diversification beyond the USA. Add to this that global equities are very highly correlated with US markets and one might well think, ‘well, what exactly is the point of going global?’
But the thing is, nobody knows what will come next. Not Buffett, Bogel, you, nor I. Over the long term, more or less anything might happen performance wise; from a continuation of the status quo through to America loosing it’s current preeminent status and being eclipsed by one or more competing markets. Nothing in the future is a given. Simply because Buffett or Bogel think it will turn out one way, doesn’t actually mean that it will, or even that it is likely to; although of course it might. The future doesn’t respect or respond to the authority and standing of those who make predictions about it. It just unfolds as it will. Going global is a way to not take a view about what might happen over time in terms of which countries’ equities might do better or worse than others. As some countries’ shares outperform, so too they will automatically make up a bigger proportion of allocations within a global tracker. And as others lag, so they get to make up less. In essence, you capture all of the upside for taking all of the downside. But you don’t have to make any choices about which countries’ shares will win, and which will lose. For some investors, it’s liberating not to have to make that directional decision.
@Time like infinity
Thanks for the input and the sound reasoning. I can’t argue against your logic, nor do I want to, so thank you for answering my initial question. Indeed, in this multi-polar world, who knows what’s around the corner. For me personally, I used to “hedge” by investing in the Ftse all- world, but I have read into the Chip Wars between China and America, the fact that there could be war over Taiwan, etc etc etc. You are completely correct…but so are Buffet and Bogle. Sometimes it’s just worth flipping that coin and guessing heads or tails.