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5 Common Misconceptions about Passive Investing

An enormous amount of flawed information has circulated in the active versus passive investing debate. That is to be expected for an argument that has been raging since disco ruled the airwaves, when John Bogle and Vanguard launched the first index mutual fund in 1976. Plus, there’s much at stake, from the salaries of fund managers to the savings of retirees.

Unfortunately for investors, it isn’t possible to try different investment philosophies like a pair of bell bottoms. Instead, choosing a strategy requires a great deal of research. Whether you lean active or passive, it is important to recognize fact from fiction so as to make a well-informed decision on how best to invest your money.

In an effort to help refine the debate, here are some facts to clear up five common misconceptions about passive investing.

1. There’s no action in passive investing

If only passive investing was as easy as placing money in an index fund and waiting for all the money to roll in. In reality, passive investors can be performers of portfolio construction, observation and discipline.

When building a portfolio with passive investments such as index funds, action starts with strategically allocating money among a variety of asset classes that can potentially help achieve a long-term financial goal. If those allocations change, more action is found with passive investors that diligently rebalance their portfolios by making trades to return assets back to their original levels so as to stick with the plan and manage risk.

2. Because of costs, passive investing achieves returns below market averages

True, but average returns are in the eye of the investor. Index funds seek to replicate a market index, so even if they accurately do, net of fees their returns will be below average. However, index funds generally have lower costs than active funds, meaning they have higher probabilities of reaching near-market averages over the long term.

Active funds charge high fees for personnel to conduct trades and research, which eat away at returns and contribute to an abysmal historical record of beating or even matching market averages. So, it’s no surprise that some studies show index funds are able to outperform the majority of active funds over time. A 2013 Vanguard study,for example, attributed better index fund performance, on average, to the inability of active fund managers to consistently beat the markets and lower expenses. That’s a pretty good average.

3. Passive investing is a cookie-cutter strategy that underperforms active investing

dollar_cookiecutterDetractors of passive investing believe passive investments can’t beat active investments since they are not tactfully managed to change with market swings or take advantage of potential future events. But, there is a benefit from passive investing’s uniformity, as the same strategy can be followed from one investor to the next.

Active investors usually shoot themselves in the foot while attempting to time the market or select promising securities because of the simple fact they cannot predict the future. A passive strategy is to stay in the market to capture its positive returns and eliminate the complex guesswork that usually proves wrong over the long run.

4. Active investors outperform passive investors during down markets

BearMarketIn a bear market, active investors typically move investments to cash in an attempt to avoid heavy losses. Meanwhile, passive investors by design stay in the market. Therefore, it’s reasonable to think active investors outperform passive investors in times of market stress. However, no evidence supports this, and in fact, data on the market timing tactics of active investors as mentioned above is not very positive.

Passive investors weather market slumps through portfolio diversification and rebalancing. And since they don’t exit the market, they may be in position to benefit on the days when it rebounds. The biggest market swings tend to happen during only a handful of trading days. In a Vanguard study of the S&P 500, eight of the 20 best days happened within 10 days of one of the 20 worst days, meaning that jumping ship can cost investors some of the market’s biggest gains.

5. Passive investing isn’t as tax efficient as active investing

Since taxes weaken returns, they’re one of the biggest concerns for investors, especially those in high tax brackets or in retirement. Undoubtedly, the IRS will get their money, but passive investing won’t help them collect.

There are minimal trades inside of index funds, making them more tax efficient than active funds, which have high turnover rates that could result in substantial taxable gains. Also, investors in high tax brackets can maintain a diverse, passive portfolio and limit their tax liabilities by investing in municipal bond funds that may have special tax exemptions.

As long as there is a market, debates over investment strategies will continue, with misleading information sure to follow. However, any investor can see through it all with facts. As Will Rogers said, “It isn’t what we don’t know that gives us trouble. It’s what we think we know that just ain’t so.”