How to Invest Your Money » Investing

Passive investing: Mixed feelings

To be interested in the changing seasons is a happier state of mind than to be hopelessly in love with spring.

~George Santayana

I’ve been thinking a lot more serious about my investment approach lately since we’ll soon be at a point where we feel more comfortable about participating in the markets again. This is based purely on the stabilization of our personal financial situation and does not by any means represent a bullish call on the stock market. I still have serious concerns about the structural problems in the markets and the economy, and the 100% run since the March 2009 lows doesn’t make me all that sanguine about putting money to work here and now.

With those caveats in mind, I do anticipate some form of re-entry to the equity world over the next 12 months or so. I wrote about how this eventuality led to my concept of The First Rule of Personal Finance and Investing last week, and a question in the comments section caused me to really think about how I feel about a passive investing strategy. The question came from a successful teacher, investor, and author Andrew Hallam. (His soon-to-be-published book is called The Millionaire Teacher and it looks like a fascinating read.)

It seems Andrew has sold all of his individual stock holdings in favor of a few low-cost index funds. He’s got a 25 year time horizon and he’s pretty confident that his positions will be “significantly higher” in 25 years. He’s not worried about the prospect of a 50% decline in the short term because he’ll be buying more at those levels and will still likely end up with some good gains by the time he’s ready to stop working.

Passive investing: I get it but …

I’ve been a little critical of passive investing in the past. In Passive Investing and the Ostrich Effect, I outlined some of the pros and cons of passive investing and drew a subtle distinction between passive investing and index investing. I can understand the reasoning behind the passive investing approach. There are reams of data that show that index investors would have outperformed most actively managed mutual funds over the past 100 years or so. (To be fair, there’s some pretty compelling active vs. passive investing research to refute those claims too.)

Leaving aside the fact that most of us do not have a 100-year time horizon, you can’t look at a 100, 50, or even 30-year chart of North American indices without noting the trend from the lower left to the upper right. Passive investors aren’t as thrilled with the 10-year charts, and they don’t want to see a 20-year chart of the Nikkei either. Those are seen as outliers.

One of the main ideas behind passive investing essentially matches my first rule of personal finance and investing: anything can happen. We cannot predict the day to day or even year to year gyrations of the markets, so it’s a waste of time to try. Heaven knows I’ll be the first to admit that predicting market movements is somewhere between difficult and impossible. So I can certainly sympathize with passive investors there.

Where’s the beef?

I guess my beef isn’t so much with the concept of passive investing itself as with the dogmatic tone that some of its hardcore proponents have taken. In some circles, passive investing is presented as the only way for intelligent investors to manage their money, with the corollary implication that those who do not embrace it are not intelligent. While I don’t deny that passive investing can be a good approach for many investors, I don’t think any single strategy fits for everyone.

Aside from the proselytizing of a few passive investors, my main point of contention surrounds the concept of secular market cycles. While the default direction of markets may indeed be upward, there are periods of time where they trend sideways to lower for more than a decade. These are the secular bear markets, and many, including myself, believe we are about 10 years into one right now. Secular bear markets are just periods of time where markets exhibit increased volatility, but end up essentially unchanged in the end.

During a secular bear market, a purely passive approach is not going to be very successful unless your time horizon is so long that you can ride out the years of flat performance, continuing to buy the dips. If that’s your position and you’ve got the stomach and the time to hang on, fine. But if like many Baby Boomers, you happen to encounter a secular bear market during the final 15 years of your working life, you may have a tougher time reaching your retirement goals.

I like to include the bigger picture cycles in my investment approach. As 2010 wound down, I wrote about Kondratieff’s seasonal cycles in Get Me Through December. It’s not that I think cycles should be the backbone of any investment approach, but that they provide the context that’s missing from a purely passive methodology.

What’s the alternative?

First, let me say that I would never tell anyone how to invest their money. I have a hard enough time trying to figure out what to do with ours. So if you look at a bunch of different approaches and decide that passive-only is your choice, I say go for it. But if you look at all of your options and opt for a more active approach or a hybrid model, I would say the same thing.

I saw an interesting take on the indexing debate in a posting on the Canadian Money Forum, which I came across via Million Dollar Journey. In it, the author suggested the following approach over your investing life cycle:

“To keep costs to a minimum, an investor should invest in a no-load index mutual fund until they have enough assets to purchase 100 shares of index ETF. Once they have enough of the index ETF to purchase the representative market (right now ~250k for TSX 60) they should sell their index funds and purchase the broader market.”

By “purchasing the broader market”, the author means buying a representative selection of individual stocks. The basic idea is that the low management fees associated with index funds can get more expensive as your invested assets grow. 0.17% of $100,000 is a lot less than 0.17% of $1,000,000. I think that’s a fair point.

Another alternative to a strictly passive approach might be to buy an index fund or two but also dabble in a few select stocks that you really like but are not represented in the index. You can also control your risk by simply adjusting your overall exposure to the markets. Perhaps you want to take a fully passive approach to invest, but you’re a little worried about market volatility, or you’re getting closer to retirement. One solution could be to simply cut the percentage of your market exposure to a level that lets you sleep at night. A 50% loss doesn’t hurt nearly as much if you’ve lost half of only a small portion of your total wealth.

There are people who are very good at trading the markets, minimizing risk and maximizing profits. Admittedly, the “average investor” (including myself) will not likely be able to accomplish this consistently. But that shouldn’t stop anyone from trying to figure out which approach or combination of approaches will work for them. It may be a passive plan, an active one, or something in between. Our approach will probably be a hybrid, although I haven’t yet figured out exactly what it will look like, and I fully expect it to evolve over time.

What’s your position in the perpetual passive vs. active investing debate?


  1. Echo

    I share similar concerns with the passive approach, and you’re right about some proponents being a tad condescending towards more active investors. I particularly enjoy the argument that “the person on the other side of the trade is smarter than you, so don’t even bother trying to buy and sell individual securities”.

    The continuous fees as well as the possibility of a downward market cycle just when I need my money most tends to keep me away from index funds. Buy the inex at the wrong time and your investment won’t go anywhere.

    • 2 Cents

      “The person on the other side of the trade is smarter …” line is one of my favourites too. It may or may not be true, but investing in an index fund doesn’t necessarily solve that problem.

      Your point about the timing of returns is excellent as well. The idea that your entry price and timing don’t matter just doesn’t sit well with me, nor does the research bear it out. I hope to have more on that topic on Friday.

      Thanks for your insights Echo! 🙂

  2. The Dividend Ninja

    Hey Balance Junkie,

    The bottom line is: Does your active picking stock strategy (becuase that’s what it is – dividends or not) give you higher returns each and every year than an index based strategy ? Does each and every stock you pick become a winner, which beats the market average ? Can you pick a stock that beats those averages time after time ? The evidence clearly states not. Andrew Hallam, Dan Bortolloti, and others have proven this for years.

    Having said that I love dividend investing, so I approach my portfolio with both a Dividend Invesitng Strategy and a Passive Potato Portfolio. Ironically my potato is doing very well this year, better than some good stock picks. The bottom line is I can’t say which is better, hence I bet my odds on both strategies.

    Have a great day!
    Dividend Ninja

    • 2 Cents

      Hey Ninja. The point of the article is not to say that Andrew’s or Dan’s approach are wrong, but that there are other methods that may work just as well or better. There are no sure things.

      I like your hybrid approach, and I intend to incorporate a dividend component in our portfolio as well. I don’t think I can pick stocks that will outperform the market on a consistent basis, but I don’t think it’s wise to ignore the secular cycles of the market either.

      I’ll be writing about some of Ed Easterling’s research on cycles and safe withdrawal rates on Friday. Again, it’s not that passive investing is a bad idea, but that the “case closed” attitude of some of its most ardent supporters sometimes misses a few necessary caveats. I’m just trying to add a little more context to the discussion.

      Thanks for stopping by!

  3. Andrew Hallam

    Here’s the tough part. If the market makes 8% in a given year, it means that the average dollar in that market made 8%. With most of the market’s money coming from pension funds, mutual funds and endowments, it would mean that the average “stock invested” dollar would have made 8%…before fees. Even in 2008, when the markets fell, the average actively managed U.S. professional underperformed the S&P 500, after fees. Of course, that shouldn’t have happened, because professional fund managers can keep money in cash, but it does show an example where market timing doesn’t work very well for most professionals. I think going with a portfolio comprised 100% of stock indexes is pretty risky, and definitely, a portfolio like that would go sideways during a period where the markets dropped 2% per year (assuming a 2% market dividend yield) But when rebalanced with bonds, returns can be decent, even during flat periods. The Canadian Couch Potato is a good example. The stock markets are currently lower than they were 10 years ago, but the rebalanced Canadian Couch Potato (33% U.S. index, 33% Canadian index, 33% Bond index) has done comparatively well, gaining roughly 200% since 1995. Only five years of this period represented a bull market, and 11 years represented a dropping market.
    Even with the flat period (down period) from 2000 to 2011, the Couch potato concept beat the majority of balanced mutual funds especially after survivorship bias. Indexing investors shouldn’t be condescending (my apologies if I ever have been) but you can see where the majority of the evidence is in their corner.
    I think people should invest in what they’re comfortable with, as Kim wisely suggests, but it’s tough to deny where the statistical probabilities lie. Indexing over any time duration (with a diversified portfolio of indexes) will be a better option than taking an active route, from a purely statistical perspective. Can active managers beat a portfolio of indexes? Of course. It’s picking that manager ahead of time that’s the tough part. He or she will definitely be in elite company.
    In taxable accounts, taking an active approach is even tougher. An actively managed fund with turnover of roughly 70% annually will have to beat its comparable index by roughly 1.2% annually just to keep pace with a low turnover index fund (if the markets make roughly 7% annually)
    Is it possible to beat an indexed portfolio during a 1 year, 3 year, 5 year period. I think so. But I, for one, am not smart (or lucky enough) to expect to do it over my lifetime. So I take the lazy approach, and index. This should put me in the 90th percentile after all fees and taxes. But I suppose somebody has to be in that top 10%.

    • 2 Cents

      There’s a difference between passionate and condescending. I’ve never known you to be anything but the former. I do see your points, and I’ve read a lot of the research in support of a passive approach. Perhaps the difference in our views is only a matter of degrees and commitment.

      I’m an agnostic by nature so I have a hard time with absolutes (with very few exceptions.) While I see the benefits of regular contributions and rebalancing as part of a passive approach, I just can’t bring myself to ignore the larger economic or cyclical variables that can and do affect market returns. If I can sidestep an oncoming train, I’ll do so, even if it means I get off the tracks a little too early and get back on a little too late. I know that won’t be the way a lot of people will want to handle it, but I think we all need to adopt a strategy that fits our risk tolerance.

      Thanks for taking the time to share your knowledge here!

  4. BeatingTheIndex

    I hate the preachy aspect of passive investing, it’s treated as the orthodoxy of investing while every other approach is deemed blasphemous.

    I have nothing against passive investing, most of my RRSPs are in balanced index funds. I also believe it fits the grand majority of people’s needs if they lack the time and the knowledge to get into active money management.

    To each his comfort zone, it’s not black or white, there’s a lot of grey in between.

    • 2 Cents

      I love the grey! 😉

      Your approach is a great example of what I’m trying to get at. You appreciate and make use of the passive methodology, but you also have knowledge in the area of resource stocks, so you make use of that too. You understand and control your risk. To me, that’s a good way to go about investing. As you said, “To each his comfort zone”.

      Thanks for weighing in here Mich!

    • Invest It Wisely

      I’m mainly with Andrew when it comes to investing for the long term and for “core” money, but as you know Mich, I also believe that if someone has the time and the passion to really get involved in a specific sector then they can do very well there, especially one as small and intimate as the Canadian oil & gas sector.

      The main “gotcha” for passive investing for me is that what happens if everyone does it? At some point returns of passive investing must decline simply because opportunities will open up, but so far it seems that human nature has prevented that from happening since too many people try to chase returns. Active investing works for the big sharks with the inside connections, but if these guys with the connections can beat the market, and index funds match it… then the difference has to come from somewhere, and that’s where many of the small guys can get swallowed up in various schemes only to end up losing money to the sharks.

  5. Rob Bennett

    I’m the biggest believer in indexing in the world, Two Cents. My view is that most indexing advocates today have little idea how big an innovation indexing really is. I think it is going to change the nature of the stock investing project in fundamental and far-reaching ways.

    I agree with you about the dogmatism of many passive investors. I believe that the problem here is that they have a lack of confidence in their strategies. We have only in recent decades begun to study investing systematically and we have made huge advances but also gotten some things terribly wrong. The dogmatics sense that their ideas don’t all add up and this makes them defensive. These are intellectually smart people who are often not as strong in the emotions department.

    Indexing DOES solve the problem of the people on the other side of the table being smarter than you, in my view. If you are of medium intelligence (you are obviously far more advantaged than that, Two Cents!), half of the investors setting the market price are smarter than you and half are not as smart. By buying an index you give up the chance of making a killing but also impose a floor on how bad you can do (no worse than the market as a whole).

    All you have to worry about are two things: (1) that the productivity of the overall economy remains roughly stable in the long term; and (2) that you not pay too high a price. Indexing GREATLY simplifies the investing project.

    I see a need to distinguish indexing (a great simplification) with passive investing, which I see as being the primary cause of the economic crisis. Passive Investors do not adjust their stock allocations in response to big price swings. I view the idea that there is no need to adjust one’s stock allocation in response to big price swings as the biggest mistake ever made in personal finance. The idea that timing is not required for all stock investors has caused more human misery than any earlier idea in the history of investing, in my assessment.

    I wish you the best of luck in your learning/investing project, Two Cents. My guess is that you will do well.


    • 2 Cents

      Thanks for the vote of confidence Rob. I’m not so confident in my own abilities. That’s why I’m going to take it slowly. 😉

      I think you’re right about the need to distinguish between index investing and passive investing. I’m not sure I’d say passive investing was the primary cause of the crisis, but I’ve read a few books and articles that have mentioned the dangers of everyone doing the same thing at the same time. When you throw in some leverage, those moves can be exaggerated further.

      I said earlier that I will probably use some form of passive investing, but I guess it’s more accurate to say that I will be indexing at least some of our portfolio.

      Thanks for contributing here Rob!

  6. Bret @ Hope to Prosper

    I have stated publicly a number of times why I’m not a huge fan of index funds. I think they are great for people who either don’t understand the market or don’t want to understand the market. They provide a solid return in the 80 percentile range and this is way better than most funds.

    For me, it has been fairly easy to pick mututal funds in the top 10 percentile and beat the index funds. Even after the higher fees of managed funds, my net return has been much better then the index funds. I think it’s worth the effort to pick funds with superior performance to the index funds.

    • Andrew Hallam

      I think that might be doable over a decade or so Bret, but over a longer period of time than that, the odds of continuing to beat a portfolio of diversified indexes with actively managed funds will diminish. How long have you been able to beat a diversified index account by picking actively managed funds?

      You mentioned that index funds “are great for people who either don’t understand the market or don’t want to understand the market.”

      But there might be a bit more to it than that. Kim’s right to suggest that there’s definitely merit to indexing–even for very sophisticated investors.

      Arthur Levitt (former U.S. Securities and Exchange commissioner) uses indexes.

      Charles Schwab uses indexes.

      And the following Economic Nobel Prize winners use indexes for their personal accounts:

      Dsniel Kahneman
      Merton Miller
      Robert Merton
      William F. Sharpe

      The late Paul Samuelson did as well.

      What do you think?

      • Bret @ Hope to Prosper


        Thanks for your question.

        I have been investing in mutual funds since 1985. Obviously, I haven’t beaten the indexes every year for the past 25 years. Some years, I have flat got my butt kicked. And, I had some transition years, when I decided to switch from one fund family to another. But, the good years have more than made up for the bad ones.

        Overall, I have beaten the index funds with no problem, especially last decade, when the indexes were flat. My investment strategy is more volatile and requires more work than indexing, but I’m not investing for average returns.

      • Bret @ Hope to Prosper

        Hey Andrew,

        You forgot to mention the Noble Prize winning Economists who bankrupted Long Term Capital Management. 😉

        Economists are the only people you meet who will give you an estimate for their phone number.

        I prefer to follow the advice of success investors, like Graham, Templeton and Buffet

        The strategy I use for selecting mutual funds comes partially from a newsletter called No Load Fund X. It’s usually near the top of Hulbert’s list.

    • 2 Cents

      Your point about index funds being a decent strategy for those with less knowledge or interest in investing is a good one. I still think they’re a good option for those with higher market sophistication as well, but I see where you’re coming from.

      I haven’t been a big fan of mutual funds myself, but if they’re working for you, why change? All of this basically goes to the main point of the article (and this blog in general) which is that you should find what works for you and stick with it. It may take some of us longer than others to figure it out. 😉

      Thanks for your comments Bret!

  7. My Own Advisor

    Personally, I think there is no clear winner. Active works better for some, passive works better for others. There are just WAY too many variables to say which one trumps the other.

    That said, for the “average investor” seeking “market returns” over a “lengthy” investment period, there is no question indexing is easy, less time consuming and arguably just as rewarding as a well-executed active investing strategy. Anyone who has invested in the equity market and stayed with the equity market through good times and bad over the last 30 years, is now probably quite wealthy.

    You’re right, nobody should necessarily ‘tell’ another person how to invest, but index investing for the most part is a solid-get-wealthy-slowly-if-you-stay-invested-strategy. Unfortunately many folks can’t stay invested in anything for one year let alone 30 years. Folks that can’t stay invested for more than one year, probably aren’t reading your blog or mine 🙂

    In my case, like Dividend Ninja, I choose to use both indexing and dividend investing because I feel a) competent with both strategies b) I’m leveraging the advantages of each strategy as part of my tailored financial plan and because of b) I’m c) reducing my overall risk.

    In the end, only you can know what’s right for you, personal finance or otherwise in life. No mixed feelings about that 😉


    • 2 Cents

      Well said Mark. For our investments, I’m leaning toward a similar mix of indexing and dividend investing. Once our nest egg is a little bigger, I may try my hand at trading again, but only with a small fraction of our total savings.

      I’m going to your blog now to read about your latest buy. Maybe I’ll add it to my growing shopping list! 😉

      Thanks for stopping by.

  8. Barb Friedberg

    As a portfolio manager with a long investing history, there’s no right or wrong way to invest. The main recommendation I can make is get into the stock and bond markets as early as you can. If you don’t have hours per week to research individual stocks, dollar cost average into a few broad based national and international stock and bond funds. Never invest money in the stock market you’ll need within 5 years.

    • 2 Cents

      That sounds like good advice Barb. I’m pretty sure I would be too nervous to stick with my investments if I need the money within 5 years.

      Thanks for sharing your experience! 🙂

Leave a reply

Your email address will not be published. Required fields are marked*