Emotions and Investing: the Myth of Passive Investing and why it doesn’t really matter

By: Joseph Thomas, CFA

The debate rages on, should you be using active management or passive management? For all the time and all the press this gets it’s really quite a silly debate. One of the most common benchmarks for passive investing is the S&P 500; the idea that this is a “passive” index is a myth.

The index is put together by a board of humans that set parameters for inclusion into the index and the process of removing or adding different companies to the index.   Since 1999, half of the companies in the S&P 500 have been removed. Commonly, stocks are removed due to being too small for continued inclusion (poor performance), stocks spin-offs, buy-outs/mergers, or other ancillary events. On average about 22 companies are added or removed from the index each year. This is neither good nor bad, but merely referring to this as a passive strategy would seem a bit of a stretch. The S&P 500, if anything could be classified as a low turnover momentum based strategy put together and managed by a board of humans.

There will be times when so-called “active” investors do better as a whole than so-called “passive” investors (they usually don’t), but focusing too much time and energy on this debate is focusing on a small factor of what will drive your investment portfolio over the long-term.

Being passive or active should be a small part of your investment thought process; being invested, staying invested, and continuing to invest will play the biggest factor in accomplishing your investment goals. Trying to time different ways of investing is difficult and even more difficult to do successfully and consistently (some may say impossible). Understand the pros and cons of each of these strategies and determine what you are most comfortable with. Even the most successful active investors don’t outperform their index every year, and more likely than not they are under performing at least as often as outperforming.   The longer-term goal is to outperform over a market cycle, which can last up to 15 years or sometimes as little as 5.

If looking to manage actively or hiring a professional to do this for you, understand that this is something that may be possible over a long period of time (although still very difficult), but not something that can be done consistently each and every year. There is definitely nothing wrong, as an investor, to focus on “passive” or “index” investing, there are more important factors to work through and consider when attempting to reach your investment goals.

Investing involves risk, including the potential loss of principal.

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