Updated on 02.05.11

Review: The Power of Passive Investing

Trent Hamm

Every Sunday, The Simple Dollar reviews a personal finance or other book of interest. Also available is a complete list of the hundreds of book reviews that have appeared on The Simple Dollar over the years.

passive investingPassive investing is a strategy that has a great deal of appeal to me, so I was quite eager to read this book that discussed passive investing as a broad strategy with great depth and reasoning.

So, what’s passive investing?

To put it simply, passive investing refers to an investing strategy that doesn’t require any kind of forecasting or predictions and thus requires very little effort to manage (thus the name “passive”). Because of that, the costs of such a strategy are quite low, meaning savings in the investor’s pocket (and thus more money to invest rather than dump into brokerage fees). Usually, this means either investing very broadly (usually meaning buying index funds that are essentially large collections of different stocks, commodities, bonds, or other investments, meaning if one fails the whole ship doesn’t go down) or investing in things that offer a very steady return (like savings accounts, CDs, treasury notes, highly rated bonds, or stocks that pay a very reliable dividend). Sometimes, you can do both at the same time.

This book, by Richard Ferri (a writer for Forbes and the head of Portfolio Solutions) and with a foreword by John Bogle (founder of Vanguard, the company where I keep much of my investments), simply makes the case for why passive investing is a very good choice for many investors, particularly those who do not have the time or financial expertise to compete with Wall Street professional investors.

The Active Versus Passive Debate
Although this section is called a “debate” between active and passive investing, it largely just makes a great case for passive investing as compared to active investing.

Let’s step back for a minute and state what active investing is. Active investing occurs when you invest in something with the goal of selling it at a profit at a later date. Doing this means not only forecasting what will happen in the market as you choose what to buy, but watching the market and deciding what the right time to sell is. You have to be actively involved with the investment.

That, of course, has a time cost. Many people choose to pay brokers and fund managers money to take care of that time cost, which would be great if such people could consistently beat the market.

But they can’t. The market is simply the average of what all of the investors out there are doing. Sometimes, a particular fund manager or broker might beat the average, but the next year, they very well might not. When you consider that you’re paying for this type of performance, why not just try to seek a way to find the average on your own?

That’s essentially what indexing does. The idea behind it is that you buy some of everything without doing any active investing at all. Then you sit on it until you’re ready to sell it. Over that period, it will have tracked the average very closely and the costs associated with it are really low.

Why doesn’t everyone do that? People often want to – or believe they can – do better than that. They tend to believe they’re above average and thus will get above average results. The problem is that simple math shows it doesn’t happen. Only half of the group actually can be above average, and with everyone competing, that above average group is constantly shifting, with people moving up and people falling back. The book estimates that at any given time, one in three investors will be able to beat the average after costs, and that one in three is constantly changing. If you’re paying a huge fee to be in this contest, why not pay a small fee and just bet on the average?

Chasing Alpha and Changing Behavior
Alpha refers to the excess return an investment bears for the risk borne. An investment with a higher alpha is one that returns very well for the risk involved, while something with a low alpha has poor returns for the risk. Loaning money to your deadbeat cousin is an investment with low alpha, for example, while finding the “perfect” stock pick has a high alpha.

Obviously, active investors are seeking alpha. They want investments that offer a return that far exceeds the risks involved. The problem is that everyone is hunting for these investments. High alpha investments don’t last very long because investors jump on board rapidly when it’s found, causing the price to go up and the advantage to disappear.

The truth is that very few people have enough investing skill to actually find investments with a high alpha before everyone else does. Those that do are usually quickly gobbled up by hedge funds or the family fortunes of the very rich. Unless you’re extremely lucky, your personal broker is not one of those people who can effectively find alpha.

Why don’t more people passively invest, then? Passive investments aren’t highly advertised and promoted like active investments are. Active investments (like managed mutual funds and brokerages) get television ads; passive investments do not because, by their nature, they’re trying to minimize costs.

The Case for Passive Investing
The final section of the book is interesting, as Ferri essentially rewrites the excellent case spelled out in the first two sections of the book and boils it down to a handful of pages targeted to various specific groups: the individual investor, charities and personal trusts, pension funds, and advisors. In each, Ferri pulls out the specific facts that are most relevant to the investing needs of that particular group.

For example, when making the case for individual investors, he argues that the best way for individuals to invest is to seek out investments that maximize return within the risk that they’re allowed to carry. So, for example, some personal investments may want no risk at all (retirement savings when close to retirement), while others can take substantial risk (your “dream house” fund).

Once you have a firm grasp on this, you simply select index funds on your own that match the level of risk you can accept. This is actually exactly how my wife and I started our “dream home” fund. We knew that we could afford some significant risk on this since it wasn’t a life-or-death situation, so we’ve put our money into a pair of diverse stock index funds that carry some significant risk (one is purely international stocks).

Is The Power of Passive Investing Worth Reading?
If you’re unfamiliar with passive investing, this is probably the best one-stop-shop book on the subject that I’ve yet read. It’s detailed enough to really teach you things, yet easy to read enough that you don’t need constant assistance in getting through the pages.

The only real weak spot of the book is specific advice – in other words, if you know how you want to invest, how do you translate that into specific funds? You’re somewhat left on your own there, but thankfully there are many online resources that will carry you on home from third base. Simply poking around the website of a reputable passive investment house (like Vanguard) will take care of what’s missing, for the most part. This book is not a book for hand-holding – it focuses on the “why,” not the “how.”

I thoroughly enjoyed this book and felt that it laid out the case for passive investing very well. Pick it up if you want some great food for thought.

Check out additional reviews and notes on The Power of Passive Investing at Amazon.com.

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  1. Jeff says:

    The Bogleheads forum at Bogleheads.org is an excellent resource to follow up on this and to get information on more specific ideas. It is a forum with a wiki full of resources and people dedicated to the idea of low cost passive investment, where active trading and market timing are shunned. Rick Ferri is a regular contributer there. I have found it is an excellent place to go for more details once you are committed to the passive investing philosophy.

  2. Sean says:

    Quick clarification on alpha–“lower” alpha is not necessarily bad. An alpha of zero means a risk/return right in line with the S&P. What you want to watch out for is negative alpha.

  3. thad says:

    I actually got to hear Rick Ferri give a presentation for this book a month or two ago – he’s an excellent speaker (it’s the 2nd time I’ve seen him). I also got my copy of this latest book of his signed by Rick Ferri after the presentation! Unfortunately, I’ve been too busy to read it all the way through yet.

    As far as specific advice for which funds to use, Rick Ferri’s book “All About Asset Allocation” is a fantastic book on which (index) funds to use for the construction your portfolio.


  4. GayleRN says:

    While I am forced to do this with my 403b money as that is the rules, the money that I can manage is returning far in excess of market rates. I find it interesting that index fund aficionadoes have a definite bias when they talk about market returns. They always assume that return will be positive ignoring the years of negative returns. I personally use it as a contrary indicator. When most of the people I work with are happy with their 403b returns I know it is time to get out. When they are most unhappy and have bailed out of their 403b entirely in favor of a vacation or new car I buy like crazy. Has worked very well for me.

    It is very true that most people are not willing or able to put in the work and time to manage their own investments. It takes years and a risk tolerance that most people simply do not have.

  5. AnnJo says:

    Even with “passive” investments like index funds, you still have to decide how much to put in each of the various indexes, and most importantly, when to pull out cash and sit on the sidelines.

    Otherwise, the long-term results are not very good. The Vanguard 500 index (tracking the S&P 500) has a 10 year average annual return (1.2%) well below the rate of inflation, and it spent most of the last 10 years in the negative numbers.

    No one will care as much about your money as you do. Delegating the responsibility for it to the market herd is the opposite of low-risk investing. When the market herd decides to turn and run off the cliff – and it will again as it has before – you’ll go with it.

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