Podcast Episode 28 – Active vs. Passive Investing Example From 2000-2010

n this episode I break out an article I saved from the Journal of Indexes May/June 2011 edition.
The article is written by Richard Ferri who wrote the book “The Power Of Passive Investing: More Wealth With Less Work” with a forward by John Bogle.

I had never heard of Richard previously but if Bogle is writing his forward well, this may be a guy who has something to say. And sure enough he does.

In his article he takes 3 different investors. One is a market timer, one simply buys and holds and the last is a buy and hold BUT with annual rebalancing.

All three have the EXACT same portfolio but just have different strategies on how to invest. Who do you think outperforms during the 2000-2010 time frame?

The third investor. That investor beat the market timer by 135% and the buy and hold investor by 38%.

But wait, I thought active managers are supposed to do better in down markets and you can’t get much more down than that decade. At least that’s what we’ve been told all these years. Yet, it didn’t happen during this time period.

Can active managers outperform? Absolutely. But one must remember where their excess returns come from. “Tactical asset allocation is a zero-sum game. When someone underperforms the market it means someone MUST have outperformed..before fees and expenses.”(emphasis mine.)

Investors who lose with their tactical asset allocation strategies indirectly provide excess returns to investors who religiously rebalance their strategic allocation. This occurs because rebalancing naturally forces investors to sell some amount of their better-performing investments and buy more of their worse-performing ones.  Although it seems counter-intuitive to do this, rebalancing increases portfolio returns and lowers risk.

Remember, folks. Investing is not trying to beat the market.  Because inherently only a few people CAN do that after fees are factored in.  And unfortunately we do not know who those few people will be in advance, only after the fact.

But more importantly investing is actually hoping the COMPANY we invest in improves its financial situation by growing more, cutting costs, increasing revenue, increasing profits etc.

A company which does that will reward its investors with a higher share price. Active trading has absolutely NOTHING to do with that company’s financial health.  Active trading is literally a gamble that costs a lot of money.

Real investing is the farthest thing from that.

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