Nothing Passive About It

by: Russell F. Coleman

Starting now, let's call low cost index-based investing just that: index-based investing. And for the reasons below let's no longer use the term "passive investing."

There's plenty of precedent for re-labeling financial terms: the speculative pools of the 1920s are today's hedge funds. And the leveraged buyout shops of the 1980s are today's private equity firms.

Why just one name?

Let's call index-based investing only just that because the term is much more accurate. There's nothing passive about low cost index-based investing. "Passive" is a common English usage opposite of "active" and there's considerable activity in index-based investing. Asset allocation is key to index-based investing and requires timely decision-making. Also key, of course, is being a costs-sensitive investor, analyzing investment costs and minimizing the "investment returns friction" of those costs. To those two activities let's add the activity of periodic re-balancing.

(Granted that index-based investing involves less time and costs than "active investing." But since when did time-efficiency and cost-efficiency become associated with "passivity"?)

And there are the milquetoast connotations of "passive": docile, accommodating, and - in an investing context - average. None of the connotations comport with desired self-image (who aspires for average?) or the American way. But in truth what fits with those connotations is not cost-minimized index-based investing but instead not being financially astute enough to know that so-called "active management," delegated to well-compensated helpers, is swimming against strong currents in the seas of investments. (… Hey let's make some money together, the helpers say to prospective clients.)

Consider two investors

Al's stockbroker (whose business card bears the title financial advisor) at a Brand Name investment firm handles all investments for Al and his family. Maybe Al met the broker at Al's country club. Or maybe the stockbroker was referred to Al by his cousin or brother-in-law. (His cousin or brother-in-law really likes the broker for his engaging social manner and because at least one stock over some favorably selected time period beat a market average, also favorably selected.) Al has no involvement with his investments except to occasionally review his monthly statement and to from time to time phone his broker about some stock his club buddies are "getting into." [The broker fancies himself a stock picker and mostly listens (patronizingly) when Al calls to kick around those hot stock pick ideas.] Al has little understanding about the true investment costs of his Brand Name account. His reasoning is that those costs can't be other than as they should be (or be material) or else Brand Name wouldn't have as many clients as it does.

Bruce studies investing doggedly and handles his family's investments, minimizing investment costs and taxes. Although in Bruce's heart of hearts he knows individual stock picking is folly, occasionally he strays into the realm of the stock picker. But mostly Bruce has the discipline to stick to a well-diversified portfolio of low cost index funds, changing asset allocations as appropriate and re-balancing periodically.

So tell me, between Al and Bruce, who could be labeled an active investor and which is the passive investor?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.