What is passive investing, and why is it better?

Passive investing is the strategy of accepting market returns and the risks that go with them, and not attempting to beat the market through market-timing or stock-picking strategies, which are both hallmarks of "active" investing.

Active investors believe they can beat the market, either by buying only the best stocks (while excluding the worst ones), or by buying into the market when they believe it's poised to climb and selling out when they believe it's poised to fall.  Despite what seems to be a sensible approach, most active investors actually fail to beat the market.  Actually, they typically underperform the market averages.

Why?  Because they incur higher costs in their attempt to produce higher returns.  Those higher costs are a substantive drag on their returns, while the higher returns are often netted against below-average returns.  

So over the long-term, active investors actually underperform passive investors.  This is a fact that has been proven by every properly-constructed independent study ever performed.

So what are the traits of a good passive portfolio:

First, selection of an asset allocation - how much you should put into stocks vs. bonds, and how much you should put of your stocks into US stocks vs. international stocks.  Answering these questions determines the amount of risk you will take and expected return you would earn.

Second, selection of low-cost and highly-diversified funds.  Actively-managed funds may have expense ratios ranging from 0.5% to 2.0%, with some additional implicit trading costs.  Passively-managed funds (sometimes known as "index funds") have expense ratios ranging from 0.0% to 0.5%, with much some additional implicit trading costs that are much lower than those of actively managed funds.

Third, discipline - maintain the previously-chosen allocation, making trades only to rebalance back to your original allocation (after it has drifted sufficiently far from the initial targets)

Fourth, go enjoy your life.  Frequently watching television shows like CNBC or reading financial newspapers and publications can cause investors to have emotional reactions that tend to cause poor financial decisions.

Fifth, consider making a change to your portfolio only when your life circumstances have changed.

At Seiler & Associates, we use funds created by Dimensional Fund Advisors (DFA) and Vanguard.

Learn more about passive investing.