Passive index investment strategies are superior, because they narrow the range of outcomes and lower your investment risk
A previous article, “The Solution – ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that individuals are much better off with a well-considered financial viewpoint. A stable set of financial beliefs can help you to keep focused and on track throughout your life. This follow-up article discusses the lifetime risk reduction benefits of passive strategies to you financial plan.
Passive, index-oriented investment strategies tend to be superior, because they narrow the range of outcomes, and thus, they reduce the total investment risk associated with your portfolio. The superiority of “passive” over “active” investment strategies was established decades ago. Two things are wrong with active strategies:
a) They increase your risk without increasing your expected gross return.
b) They cost more and thus lower your expected net return.
Those who perpetuate this spurious “debate” usually make money from active investment fees and other costs, either directly or indirectly. Just ignore them. They will never really go away or stop talking, but you do not have to listen to them or believe them.
Most often, those who argue for passive investing do so by arguing that on average the lower implementation costs of passive investment strategies will increase net investment returns. The most succinct presentation of this lower-cost-higher-returns argument is Professor William F. Sharpe’s elegant two-page paper, “The Arithmetic of Active Management,” published in 1991 in The Financial Analysts’ Journal.
While the relative costs of active and passive strategies are very important, the higher risk and higher uncertainties of active strategies are just as important. Unpredictably, active strategies can lead either to significantly higher or to significantly lower returns. The key issue is that active strategy outcomes are more unpredictable even before any higher costs are considered. Active strategies introduce a very large and completely unnecessary element of added lifetime personal financial planning risk. To the contrary, passive strategies narrow the range of your outcomes. Because passive strategies target a market return, the expected variance around the market return tends to be much narrower than the variance around more active strategies.
Studies of actively managed equity growth mutual funds illustrate this point. See “How many mutual funds are needed for a well-diversified portfolio? – a commentary” which discusses a study by Professor Edward [...]