How active and passive investors end up in the same place

Posted by on August 17, 2010 in Investment Information

After several years off, I have been dragged back into playing golf this summer. I am a hacker and, although some of my friends won’t admit it, so are they. If you play golf for any period of time, you probably have noticed the following pattern if your golfing buddies are hackers. Someone in the group with some fundamental flaw in their swing decides the solution is to buy a bigger/better/faster/sexier club that will fix all their problems. Of course, in most instances, this  club makes their slice or pull that much more apparent. The result is that the 50 yard slice right into the rough is now 100 yards slice right into the bush with their new toy and the “obvious” solution is to buy the even bigger/better/faster/sexier club next season.

I feel the active vs. passive investing debt has this similar type of feel. Many people have sliced their portfolio into the rough using active investing methods but, instead of mastering their own emotions, they decide the problem is with the active investing club and go out and buy themselves a passive investing club.

(to be clear, the evidence is pretty over-whelming that high fee active management products make no one rich but the issuer but low fee active management options have existed for many years and the poor returns of many active managers is compounded by many of the errors committed by the investor below)

The passive investment may offer advantages to the active investment BUT ONLY IF IT IS DONE RIGHT. Please remember that the fundamental assumption underlying the advantages of passive investing is to invest broadly in low fee products, allocate among asset class properly, reallocate periodically and to stay invested. Without any of those factors cited above, moving from active to passive investment is equivalent to getting a new golf club without taking any lessons to fix the real flaw in the first place.

Morningstar now estimates slightly over 1 in 5 investors now have some type of passive investment strategy in their portfolio. Where there is money, there’s the financial industry to screw you out of it. Thus, there are now products that are not really passive but claim to be, issuers encouraging investors to purchase a multitude of niche products and products which promote quick-turnover by their very nature (most leveraged exchanged traded funds).

The potential result for an investor pursuing perhaps the right strategy from them (passive) but executing it poorly may look surprising similar to the strategy they previously abandoned: too many products being turned over too quickly with some products not even doing what they are supposed to be doing. To go back to my golfing analogy, the club may be different but still the same old hacker.

There’s an old saying in business: invest in a company with a Grade B idea and Grade A execution over one with a Grade A idea but Grade B execution. The same rule applies to investing. Sticking to a plan, controlling one’s emotions and tuning out the imperative to buy marketing buzz will get you farther, regardless of strategy, than constantly changing approaches, being emotional and relying on the supposed superiority of the plan and not in its execution.

5 Comments on How active and passive investors end up in the same place

By larry macdonald on August 17, 2010 at 10:31 am

Some good points here. Passive investing is best for DIY retail investors because they don’t have a lot of time to do the research for an active approach (having their own careers to attend to). But passive investing isn’t a “magic golf club” if they are not in control of their emotions, etc.

By Canadian Capitalist on August 17, 2010 at 12:58 pm

It is perhaps too much to expect the financial industry not to roll out new products when there is so much demand for them. I like your golfing analogy. Passive investors chasing returns and trading furiously are going to end up with active investor like results.

By » Weekly blog roundup Canadian Business Blogs | Advice on Investment in Canada, Stock Market, Small Businesses Opportunities on August 23, 2010 at 12:04 pm

[...] a hiatus, which perhaps explains the metaphor in his post on why passive investing isn’t a magic golf club if you don’t have the right swing. Other posts in this week’s blog roundup [...]

By Weekend Reading | In Search of Salt on August 23, 2010 at 1:49 pm

[...] I thought this post at Thicken My Wallet was great: it compares switching investment strategies to thinking you can be better at golf by buying a more expe… [...]

By Dale Rathgeber on August 23, 2010 at 4:03 pm

This is your best post in a long time. Well done.

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