5 Reasons to Give Up On Active Investing

“Active management is little more than a gigantic con game.” Ron Ross, Ph.D

We all want to be better than average, it makes us feel smarter. Who hasn’t been enticed by a big glossy ad from a fund manager showing their amazing outperformance over the previous 1 or 3 or whatever number of years. If only I could invest where the smart money is!

Active investing means aiming to get a higher return than the market index. You are hoping that your fund manager, broker or your own stock picking skills will achieve this year after year.

So giving up on active investing means that you accept the certainty of achieving the market return. It’s not an easy choice because it goes against the idea that if you are smart or invest with the smart guy on your team, you can beat the market.

These are my 5 reasons to give up on active investing:

1) Avoid the Marketing Machine and the Market Noise

“If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what`s going to happen to the stock market.” Benjamin Graham, 1976

Fund managers and brokers are smart people and they generally have big marketing departments aimed at getting your investing dollars. I’m willing to guess that just about every investor ever has at one time in their life been sucked into investing in the next big stock, fund or investment.

When you give up on active investing here are some questions that will no longer matter:

What is the outlook/forecast/future for the share market? (which no one can really answer by the way!)

How will the tension in the Middle East or the economy in US/Ireland/Greece affect my portfolio? (do you really want to worry about this??)

And if you’re relying on newspapers or magazines for your investing insights – good luck with that. Try keeping track of a few headlines from the business section each day for a couple of weeks – it will do your head in!

2) Focus on What’s Important

“An investment in knowledge pays the most interest.” Benjamin Franklin

One of the big benefits of taking an index approach is that it allows you to focus only on those things you can control. Instead of spending countless hours trying to beat the market or find the next big thing, think about the aspects of your life that deserve your focus. For some ideas on this check out this post.

One of my favourite quotes from a client is from a retiree who said “I used to look at my portfolio almost every day, now I’m lucky if I look at it once every 3 months”. Do you really want to be waking up every morning to check the overseas markets and waste away your day watching CNBC or Bloomberg?

3) We Are Not Emotionally Wired for Active Investing

“The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine.” Jason Zweig, 2007 – Your Money & Your Brain

One of the most interesting areas of study in investing is behavioural economics. While most of the academic research in this field requires a PhD to understand, there are some really useful basic concepts to know about. Herd behaviour is the tendency of individuals to follow the actions of a larger group.

In investing this is best illustrated by buying high and selling low. Think about some of those stocks back during the tech bubble – no earnings, in some cases no product but they built this momentum that saw their price rise and rise until the bubble popped. The chart below is a great example of how herd behaviour occurs in the US equity market:

Source: 2012 Morningstar Equity and Bond Fund Flows

4) Performance

“Most investors, both institutional and individual, will find that the best way to own common stocks (shares’) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.” Warren Buffett, 1996

With hindsight it is easy to see where you should have invested your money but that is not much help for the future. A Vanguard research paper in 2013 titled “The Bumpy Road to Outperformance” stated the following in relation to the difficulty of picking active managers:

“Looking at the 15-year records of all the actively managed U.S. domestic equity funds that existed at the start of 1998, we find that not only are long-term outperformers rare, accounting for only 18% of those funds, but they also experience numerous and often extended periods of underperformance.”

5) Cost

“The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time..” Warren Buffett

Index investing is cheap in comparison to an actively managed equity fund where you’ll typically pay around 1%pa. And plenty of these funds promise the world but are really not much more than an index fund in disguise, dressed up as active in order to charge higher fees! Your ongoing cost can increase to 1.5%pa for more specialist managers and 2%pa or more for hedge funds.

Like anything though it’s not just about being the cheapest. This should just be one reason, not the only reason.

What do you think of my 5 reasons? Have you got another one to add? Or do you believe active investing will provide a better outcome? Why?

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