The money manager and columnist Barry Ritholtz makes a timely and important point in his most recent opinion piece for Bloomberg: Passive investing is an illusion.
Nobody is truly a passive investor because all investing involves selection. Even if you choose the broadest possible global stock index fund, you’ve still chosen some stocks and ignored others.
And even if you buy that global fund, put money into it to every year and never sell, you’ve still chosen stocks and ignored bonds, real estate and other potential investments.
That’s not to say you won’t succeed as an investor. For a young investor with a long time horizon, a global stock index fund can be a great choice.
Still, Ritholtz contends, don’t call that form of investing “passive.” Instead, as Vanguard Founder Jack Bogle demonstrates over his long career, call it “low cost.”
Even index investments involve a concrete choice to buy certain stocks over others. If you invest in a standard S&P 500 Index fund, for one, you will be getting a selection of stocks that is weighted by market capitalization.
Without getting too technical, “cap” weighting means you own more of the biggest companies in an index. It’s like valuing a basketball team based on each player’s statistical contribution to the outcome — points scored, rebounds and so on.
Bogle’s argument is not that cap weighting delivers superior returns but that it is the cheapest way to own the stock market. There are plenty of alternatives to cap weighting, such as risk weighting, fundamental weighting and on and on.
If you believe that you can judge a company’s prospects by examining it closely and, crucially, that you can accurately predict the returns of hundreds of firms, some of these alternatives might make sense.
Bogle’s view, of course, is that the money on the table is not from selection but from eliminating the fees you pay for active managers. That makes the equation extremely easy. Be frugal. Take the low-cost option, always.
Now, back to our young, risk-tolerant investor. He or she likely should buy that broad, global stock index fund and move on.
The data show that stocks are by far the long-term winner compared to other common asset classes. Globally diversified stock returns are likely to shine brighter still, thanks to global growth.
But not everyone is a 20-year-old with decades of investing ahead. Thus we begin to consider another level of choice, and move still farther from truly passive investing.
Portfolio index investing is about making choices. It’s owning a variety of investments — both domestic and foreign stocks, large companies and small, both domestic and foreign bonds, plus real estate and additional income investments. And owning specific measures of each based on your personal tolerance for risk, that is, your true investment horizon.
Of course, following Bogle’s lead, you should own these asset classes in the form of low-cost index funds, and you should periodically rebalance them.
Here, the data is clear. Research conducted by Burt Malkiel, author of A Random Walk Down Wall Street and a member of the Investment Committee of my own firm, Rebalance, shows that asset-level diversification and rebalancing improves returns while lowering risk.
Better returns and lower risk. It sounds impossible, but it can be done. Add in the low-cost philosophy of John Bogle and you get performance that counts.
Nothing passive about it.