The Power of Passive Investing

Last Updated Jan 31, 2011 10:25 AM EST

Do you feel lucky? Well, after reading Rick Ferri's new book, The Power of Passive Investing, let's hope you are if you're planning to bet against the power of passive investing. Here are some key points from Rick's great new book, with a forward written by none other than Vanguard founder, Jack Bogle.

The illogic of the active vs. passive debate
Though many active investors claim this debate will never be settled, they point to market anomalies as evidence the efficient market hypothesis (EMH) is flawed. Ferri is one of the few who refuses to take the bait and notes what Nobel Laureate, William Sharpe, wrote about years ago. Active investing as a whole must underperform passive. And the reason it must is because passive earns the market return less a low expense, while active earns the market return less a much higher expense. It's simple arithmetic that settles the debate, making the EMH about as relevant to the argument as the price of tea in China.

The odds of a single fund beating the index aren't so bad
Beating the broad low cost index fund has proven to be a difficult task. In fact, it's much more difficult than beating the Wall Street Illusions of besting the S&P 500 index, stripped of dividends. Ferri condenses the wealth of academic research to show that roughly 42 percent of active funds beat their benchmark index fund over any given year. The odds drop to about 23% over a ten year period.

The odds of a portfolio beating an index are dismal
In his book, Ferri points out that few investors own only one fund. He quotes some academic research, including a study from yours truly, that frame the odds of multiple funds beating index funds over a period of years. The odds of a 10 fund active portfolio beating the index over a 25 year period drop to less than one percent or, in other words, has a 99 percent chance of failure.

Your odds are low but so is your payoff
Taking into consideration that active investing has low odds, then the only rational argument to utilize this strategy would be that it must have a high payout. And if you happen to be in that lucky one percent, it's a done deal that you'll get rich, right? Actually, not so much. Ferri looked at the payout of both the winning and losing active funds and found a very different outcome. The average payout from those winning funds is not nearly enough to compensate for the losses of the losing funds. Or, to put it another way, active investing takes on more risk for a lower expected return.

5 Steps to building a passive portfolio
Ferri goes far beyond showing the odds and the payouts of active investing. He actually walks the reader through the process of constructing a great passive portfolio.

1. Determine the portfolio's objective.

2. Analyze various asset classes.

3. Create a strategic asset allocation.

4. Choose the low cost securities.

5. Implement and rebalance.

My conclusion
One of my favorite quotes ever is from Matthew Emmert, of the Motley Fool:

"The best thing you can do as an investor or a gambler, is to know the odds of the game you're playing--because not knowing them will cost you."

If investors truly knew the odds and the payout from active investing, few would take their nest eggs and try to defy those odds. Ferri makes such a compelling case for passive investing, that it should be required reading for every trustee of pension funds and endowments.

If you are a passive investor, this book will validate your investing path and confirm your brilliance. If you are on the fence, it will tip you over to higher returns with less risk. If you are employed by Wall Street, you'll hate it with a passion.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.