Passive Investing’s Primary Error: It’s (Mostly) Imaginary

OK, so maybe this strategy is more imaginary than passive investing, but still. Photo by Tristan Fewings/Getty Images Entertainment.

I am not a fan of writers quoting themselves generally, but I'm going to do it just this once anyway because, well, I can't think of a new way to begin another article about passive investing.^[i]

Just as you can't be a little bit pregnant, you can't be a partially passive investor. Owning a passive product does not a passive investor make.

Now, a wise woman once beat into my brain, "Clarity is a social matter." Over. And over. And over. If it isn't clear to other people, it doesn't matter how clear it is to you.^[ii] With that in mind, I'd like to revisit passive investing and perhaps spell out exactly why I have such absolutist, black-and-white thoughts about passive investing, a subject that for most folks is probably not very controversial. But my take on passive investing remains unchanged: I am unconvinced it actually exists, and if it does, it is not nearly so common as most investors and pundits presume.

First, let's clarify what I mean by, "passive investing." It is:

1. The belief markets are so efficient investors cannot beat them with any repeatability over time.
2. So why try? Once you have an asset allocation, select an index to mirror.^[iii]
3. Buy an index fund to mirror that asset class.

That all seems simple. But a key here is the modifier "an." As in one. Only one. Why? Because the moment you start mixing and matching index funds within the same asset class-within stocks, most often-you violate step 2 and unwittingly invest counter to step 1. You become an active investor because the weightings you assign to these categories are determined by, well, you. Voila, pregnant! You are no longer mirroring any index in total. You've deviated, even if you never pick a single stock or even think you're trying to outperform. Now, for the record, owning more than one fund is fine, folks. It just isn't passive investing.

Yet in most of the essays lauding passive investing, the proponents argue for the use of multiple funds-indexing to multiple indexes. These investors claim doing so will improve performance relative to an active fund investor, yet evidence this is categorically true is lacking. All the evidence compares fund A to fund B, but that begs the question. (And yes, I get that there is evidence passive funds generally top active.) Both investors are charged with making asset allocation decisions. Both are charged with determining categories of stocks to select from. The only difference, and I'd argue, the least impactful one, is the stock selection method. How those active decisions play out will determine which portfolio does better-they determine whether you pick the better-performing portfolio of funds in the first place.

I would maybe give some ground here if the proponents explained their weighting rationale, but alas, in the dozens and dozens and dozens of articles I've read on the subject, I've never seen that done in a fashion compatible with the basic, markets-are-too-efficient thesis underpinning passivity. It most often seems arbitrary, and less often built on the assumption different classes of stocks (foreign, small, etc.) aren't equal. A strict efficient markets adherent (passive investor) should probably reject the argument that a certain class or category offers superior returns or is riskier or anything along those lines. To believe otherwise is to buy into market inefficiency, and a lasting inefficiency at that. (This belief has its troubles, an article for another day.)

This is all a very odd place for a passive investor to wind up. You see, the whole reason markets can be beaten, according to active investing theory, is that markets are not perfectly efficient. That in the short run-a minute, month, year-markets do not perfectly rationally reflect reality. This is because a market is nothing more and nothing less than a mass of people. Masses of people are subject to mass psychology, which includes features like mass hysteria, which provide an opportunity for the investor who is able to see the current state of mass psychology clearly for what it is. This is not merely euphoria, mind you. This is also identifying where investors are irrationally pessimistic about the future and investing before they awake to their own irrationality. That humans are irrational and humans constitute markets means that markets aren't perfectly rational all of the time.

I am not ruling out the possibility that there are passive investors, just that most folks' passivity is actually something they just imagined-most passive investors are just actually active investors who don't stock pick. I am aware of no evidence, nothing to support the argument individual investors spreading their money across an array of index funds they chose in weights they determined categorically outperform investors who choose active funds and do the same. My bet is the vast majority of investors doing either likely perform pretty poorly over time, assuming they even stick with their strategy long enough to find out.