Find out if passive investing is really worth it in the long run.
When it comes to investing, there are two broad strategies or philosophies: active investing and passive or lazy investing. In this post I’ll give you the major pros and cons for each strategy, tell you what the researchers say, and give you an important tip to boost your investment returns.
What is Active Investing?
First off, let me explain active investing. An active investor likes to buy and sell various kinds of investments, like stocks, mutual funds, exchange-traded funds, and commodities on an ongoing basis. They keep a close eye on the markets and make decisions like buying a stock when the price dips and selling it when the price goes up, so they can make an immediate profit. The goal of an active investor is to time the market in order to take advantage of short-term price movements.
As you can imagine, if you’re really good at active investing, the upside could be massive. But if you’re not, an investment that turns sour could leave you with massive losses. Not only can timing the market be risky, but it can be expensive because you generally have to pay a trading fee every time you make a transaction, which can really take a bite out of your earnings. Additionally, it takes a certain level of expertise to understand how to read performance charts, use professional trading software, and understand how changes in different types of industries and interest rates relate to the future price of your investments.
What is Passive Investing?
On the other hand, passive investing is just what it sounds like. It means you really don’t do much, hence, the lazy factor. Passive investors take a long-term view of investing, which is also known as a buy-and-hold strategy. The idea is that they make consistent, but limited purchases of investments that should appreciate over long periods of time. They don’t consider owning stocks that are exploding in growth so rapidly that they might self-destruct. Those types of volatile investments are the ones that active investors will gladly snap up. A passive investor typically buys fundamentally strong companies (or funds that own those companies) that are likely to continue making profits for decades to come.
Can Being a Lazy Investor Pay Off?
But the question you’re probably asking yourself is whether lazy investing pays off. Who’s more likely to make more money over time, an active investor or a passive one? There’s been lots of research about this topic, but I want to highlight an article by Mark Hulbert who writes for the American Association of Individual Investors (membership required). He’s been tracking advisor portfolios for over three decades and says that about two-thirds of them would have made more money if they had been much less active.
Hulbert says that for 2010 alone, 500 different portfolios he examined gained an average of 14.6%. That’s a pretty great return—but get this: If those same portfolios had not engaged in active trading—if they just held on to the same investments from January 1st through the end of the year—they would have made 18%! Even in 2009—when the market plunged on March 9th and then made a run up—the average portfolio would have come out ahead by almost 1% if absolutely no trades had been made.
Why Being a Lazy Investor Can Pay Off
Hulbert also cites an academic study that scrutinized the trades made in 10,000 random brokerage accounts of individual investors from 1987 to 1993. The study focuses on cases when active investing occurred, where the account owner bought and sold a stock in fewer than 30 days. The researchers found that in the 12 months after the stocks were sold they performed better than the stocks that were purchased to replace them.
In other words, the data reveals that investors are prone to selling out too early. If the investors had been lazy and kept their investments, they would have earned a return that was 3.2% higher than what they got! The point of Hulbert’s article is to demonstrate that making more transactions lowers portfolio returns. A well-known economist named Gene Fama Jr. is credited for saying, “Your money is like soap. The more you handle it, the less you’ll have.”
Why Lazy Investors Can Make More
Many companies and researchers who study investor behavior find consistently that the average investor earns below average returns. The reason we do so poorly on our own, when compared to historical market returns, is due to our human nature. When the market drops, we panic and sell at the very worst time, when prices are low. And when the market shoots up we get greedy or finally get the confidence to buy—again, at the very worst time, when prices are high. We chase trends and overreact to news, which can lead to very irrational and bad investing decisions.
How to Increase Your Investment Returns
My quick and dirty tip is to boost your investment returns by becoming a lazy investor. I’m not saying that you should never make a trade, but I do believe that becoming an active investor shouldn’t be taken lightly. If you do have a passion for trading, be prepared to spend at least as much time doing your homework as you would working a part-time job. For most people, sticking to a passive strategy where you contribute money to a retirement or a non-retirement brokerage account, like Betterment, in a systematic way will give you plenty of investment returns for much less effort. There aren’t too many areas of life where being a couch potato can pay off—but isn’t it nice to know that investing is one of them?
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