Improve Your Understanding of Passive and Active Investing

Mr. Armstrong greatly oversimplifies and misrepresents passive investing. His comment that "if an investor employs a passive strategy and the market goes down, he or she will participate in that market decline one-for-one" suggests that the passive investor has all of his or her assets in one index fund. This is not how passive investing works. He writes that "an index, because it is not managed by a human, cannot take any precautions to protect the portfolio when the markets decline." But a portfolio can be diversified appropriately through thoughtful asset allocation to protect the client's investments.

A good passive investment advisor will structure a diversified portfolio of index funds and asset-class funds in accordance with the client's investment goals and risk tolerance. If someone has a good passive strategy in place, he or she will own very low cost funds that provide exposure to domestic (large and small) equities, fixed income, international (large and small) and emerging market equities as well as other asset classes such as REIT funds, all in a proportion appropriate to his or her life stage, wealth and investing goals. So when "the market goes down," such an investor should see other asset classes appreciate or hold steady, assuming that they have an appropriately low correlation to the particular "market" or index that is in distress. Obviously extreme market conditions change the game for all investors, active or passive.

Passive advisors can also "tilt" a portfolio toward small cap and value stocks to provide additional returns over a simple index. Research shows that there is a small cap/value premium over time. Passive investors don't suffer from market timing mistakes (because they don't try to time the market) nor from poor stock picks, because they don't pick stocks. They keep costs low and earn market returns on the asset classes they hold. With appropriate rebalancing to lock in gains, passive investors outperform active investors.

Passive Investor of MD 10:20AM January 12, 2011