Passive Investing Doesn’t Work

A commonly known cliché is “if you can’t beat them, you should join them.”

For the past couple of decades, Wall Street has been touting to the millions of part-time investors (mums and pops) that passive investing is the way to go. Just understand a little bit about P/E ratios, historical lows, added with 30 minutes of monitoring the financial news a day, and presto! You’ve just got the secret formula to consistently beating the stock market year after year!

Unfortunately, things aren’t as simple. Let’s put it this way. The S&P has compounded at an average of 8.5% year over year since it’s inception. So let’s assume that those millions of mums and pops are using the “secret formula” mentioned above, and they’re all managing to beat the stock market average of 8.5% a year. But hold on a second. What does the word “average” mean again? If all those mums and pops are earning investment returns of more than the S&P average, then who’s earning less than the average? George Soros? Barry Ritholtz? I don’t think so.

If you don’t want to hear the truth (and the truth hurts), please don’t continue reading. But if you do want your investment skills to improve, then read on!

There are millions of part-time, unsophisticated investors out their touting that with their easy going, buy and hold investment strategy, they can consistently perform better than the stock market average. That simply doesn’t make sense. Or else we wouldn’t need full time investors, or hedge fund managers. They would all want to become passive investors and easily beat the stock market averages! And if everyone were consistently beating the average, then 8.5% year over year average wouldn’t exist! You can’t consistently beat the stock market average with passive investing. As my kung-fu master would say “if the game were so easy, everyone would be winning at it.” Like any game, the pros always beat the newbies.

My point is, there is no way that people who don’t want to actually learn about investing (with their easy going investment strategy)  can consistently beat the average. Investing isn’t as simple as it sounds. It’s not as simple as Warren Buffett says “buy when others are fearful, and sell when others are greedy.” The markets may be oversold, but they can be far more oversold. The markets may be overpriced, but they can be far more overpriced. If investing was as simple as following a single quote spoken by Buffett, then there would be no other investment strategies. There would be no technical analysis. There would be no full time legendary investors like Jeremy Grantham consistently trying to piece together what’s going on in the markets. Passive investing is like asking me to beat Lionel Messi in soccer (I practice 4 hours of soccer a week). Sure I might have a streak of luck and score a goal, but over the long run, Lionel Messi’s going to destroy me.

There is simply no way that an unsophisticated passive investor can select a great diversified group of stocks that consistently outperforms the market average. What do you think those full time stock pickers are doing all the time? Picking stocks of course!

So if those millions of mums and pops can’t beat the average, what should they be doing? Just buy the average of course! Buy a Dow ETF or S&P ETF, and hold it forever! That way they’ll earn exactly the stock market average (8.5% year over year), and they won’t be making any stupid mistakes such as accidentally selling the good stocks in their portfolio and keeping the bad ones. Buying a S&P ETF and holding it forever truly is passive income. If you can’t beat the stock markets’ performance average, join them.

This guest post was written by Tony Chou, who teaches people at Investorz’ Blog how to invest in the stock and commodities markets. Tony also frequently dishes out his outlook on the financial markets and macro economy.