Passive investing is a stupid idea – there’s no such thing

Passive investing is a stupid idea.

I know, I know. You’re sitting there thinking: “Hang on a minute, Stepek – you’re always getting on your high horse and telling us that fund managers are useless and we’d all be better off with cheap passive funds. What gives?”

So just to be clear – most fund managers do underperform the market, and you shouldn’t pay their whopping great fees when you can get a cheap, simple tracker fund that will do much the same thing for a lot less money.

It’s not cheap funds I have a problem with – it’s the description.

Passive investing is a stupid idea because there’s no such thing…

You couldn’t be passive if you tried

Like a lot of financial jargon, the word ‘passive’ gives entirely the wrong view of what ‘passive’ investing actually is.

Everyone is an active investor. When you are deciding what to invest in, and how much of your money to put in it, you are making an active investment decision.

Let’s say you want to invest some money in shares. You decide that 60% is about right, given your own target retirement date. That’s an active decision – why not 50%? Or 70%?

You decide that about half of that 60% should be in UK-listed shares. That’s an active decision. Why not all of it? Or a third of it?

You haven’t got anywhere near picking an actual stock yet – and you may not at all – but you’ve already used your judgement to make two significant decisions on where and how much to invest. There’s nothing passive about that.

And once you’ve made these big ‘asset allocation’ decisions, there’s the question: “How do I invest in UK stocks?” Even if you don’t want to buy individual stocks yourself, then you have to choose which financial ‘vehicle’ you’ll use to play the market.

It’s generally at this point that you face the choice between an ‘actively managed’ fund – where a fund manager picks stocks in the hope of beating the market – or a ‘passive’ fund, which just tracks the performance of the underlying market.

But even here you have to then make a decision on which of the wide range of funds – both ‘active’ and ‘passive’ – to choose from.

So this idea that you can ever truly be a ‘passive’ investor is just nonsense. Because by the time you get down to the level of choosing which particular fund you want to use to play a theme, you’ve already made the most important decisions – various studies show that asset allocation has a lot more impact on your returns than individual stock selection.

(And even if you pay a financial adviser to do this job for you, you still have to sign off on their decisions. So you’d better make sure you understand what they’re investing in on your behalf).

This is why you need to understand how to invest

So the idea of ‘passive versus active’ investing as it’s generally framed in the financial media (and we’ve been guilty of it too) is too simplistic.

You have to take active decisions whether you like it or not. And that means, if you want to have any hope of reaching your financial goals, you need to have some understanding of the investment process.

Investing is not about following hot tips or taking random punts in the hope of winning the lottery at some point. It’s about working out how much money you’ll need to meet a particular financial goal, and then working out the best way to save and invest to get to that point.

That’s a tricky business in an uncertain world. Plans change. Goals move. Unexpected stuff happens. That’s life.

But there are a few things we know for sure. We know that we can’t predict the future. So we need to avoid building a portfolio whose success hinges on one particular economic outcome. We need to ‘diversify’.

We also know that the more money we spend on the investment process itself – in other words, on broker fees, and manager fees, and trading costs – the less there is to put in our pot.

This doesn’t mean that you should always opt for the cheapest option. When it comes to brokers, you need to think about the range of services you require as well.

And some active funds manage to outperform regularly enough to be worth considering instead of a tracker fund. As a (very) broad rule of thumb, investment trusts have tended to outperform both tracker funds and open-ended investment companies (Oeics) in the past.

And the more obscure the market – emerging and frontier markets say, or small-cap stocks – the more likely it is that an active manager will be able to justify their fees.

So cheap doesn’t automatically mean best. But it’s important that if you opt for a more expensive investment option, that you understand why, and that the extra cost can be justified.

There’s a lot more to investing than this of course. But if you set realistic goals, avoid taking all-or-nothing bets, and keep your costs under control, you’ll already have gone a long way to setting yourself up for success.

My colleague Phil Oakley has put together a fully diversified portfolio built out of cheap exchange-traded funds for his Lifetime Wealth newsletter. If you’re looking to get started in investing, or are looking for guidance on how to take charge of your own finances, I can’t recommend it highly enough – find out more here.

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