What Is Passive Investing?

Beyond Buy-and-Hold #36

I recently hosted the April Carnival of Passive Investing. It would be nice if I could say with certainty that I am a passive investor.

I think I am. But there are some who would argue strongly that I am not.

Shouldn?t we know the answer to this painfully basic question? Just what is Passive Investing?

I don?t believe that there is anyone who can provide a clear answer to this question. And that?s a remarkably strange reality that says a lot about the confused state of the world of investing expertise.

The cause of the confusion is the ambiguity present in the word ?passive.? ?Passive? is the opposite of ?active.? A passive investor is an investor who elects not to take some action that other investors do elect to take. But what is this thing that passive investors choose not to be active about? Depending on what it is that passive investors don?t do, I am either the world?s strongest advocate of Passive Investing or its harshest critic.

Many investors pick stocks. If being a Passive Investor means investing in indexes rather than picking stocks, I think it would be fair to characterize me as the world?s leading advocate of Passive Investing. I make claims for indexing that no one else has made. I say that Valuation-Informed Indexing permits investors to obtain greatly enhanced returns at dramatically reduced risk. I am obviously a big-time proponent of indexing.

Many investors practice Buy-and-Hold asset allocation strategies. That is, many investors choose not to change their stock allocations in response to big valuation shifts even though by failing to do so they permit their risk profiles to change dramatically. I am certainly not passive in that respect. I often describe Buy-and-Hold as the purest and most dangerous Get RIch Quick scheme ever concocted by the mind of mortal man. I think it would be fair that there is no one alive today offering more severe criticism of the Buy-and-Hold concept.

Are all indexers passive?

If they are, I am a Passive Investor.

Are only Buy-and-Holders passive? If that?s the case, I want nothing to do with Passive Investing.

Are Buy-and-Holders passive even if they pick stocks? In that case, Warren Buffett is a Passive Investor even though he doesn?t know it. Someone should tell him!

No one knows what Passive Investing is. No one has ever bothered to define the term with sufficient clarity to be able to say who belongs within the Passive Investing circle and who does not.

This has caused a great deal of confusion. The biggest investing discussion-board community on the internet is the community that meets at Bogleheads.org. I participated actively in that group during the time it met at Morningstar.com and was one of the most popular community members (I was also one of the most hated community members by a large and vocal group of Buy-and-Holders, to be sure). The site administrator at Bogleheads has let it be known that he will ban anyone who posts in support of me or my investing ideas. Why? He says that I and my investing ideas represent ?a threat to the community.?

Huh? Little old me? And my little old investing ideas?

The site administrator acknowledges that I never posted abusively and a good number of community members have identified me as one of their favorite posters. What sort of threat could I possibly represent?

I don?t represent a threat to the Bogleheads community. But I do indeed represent a threat to something. I represent a threat to Buy-and-Hold.

I point out the dangers of Buy-and-Hold all the time. I advocate an investing strategy (Valuation-Informed Indexing) that can fairly be described as the opposite of Buy-and-Hold. So, if that board is only intended for Buy-and-Holders, I really should be banned. If one must swear allegiance to Buy-and-Hold before signing up there, I truly do not belong.

But wait.

The only difference between Buy-and-Holders and Valuation-Informed Indexers is that Valuation-Informed Indexers believe that valuations affect long-term returns. I learned about the importance of valuations by reading a book titled Common Sense on Mutual Funds. The book was written by John Bogle, the fellow from whom the Bogleheads board took its name.

I?m banned from Bogleheads because I believe what John Bogle wrote in his book!

Could anything be more strange?

Passive Investing was developed at a time when the research showing that valuations affect long-term returns had not yet been published. It?s not hard to understand why Passive Investors believed what they did at the time. But Passive Investors purport to believe in following research-supported strategies. The research has been showing for 30 years now that valuations affect long-term returns.

We need clarity.

Either passive investors believe that valuations affect long-term returns or they do not.

If passive investors believe that the market is efficient, it should not only be Rob Bennett and those who post in support of him who should be banned at Bogleheads; John Bogle and those who post in support of him need to be banned too.

If passive investors want to continue to claim support in the academic research for their strategies, they need to make clear that they no longer support Buy-and-Hold asset allocation strategies. They need to make clear that it is a belief in indexing that is today the distinguishing characteristic of Passive Investing.

Rob Bennett is the most severe critic of Buy-and-Hold Investing alive on Planet Earth today. Rob?s bio is here.

( Photo from Flickr by Helico )