Why People Still Question Passive Investing Despite the Data
In the world of investing, the debate between active and passive strategies has been a longstanding one. Over the past few decades, passive investing has gained substantial traction, with a growing body of evidence suggesting that it often outperforms active management in the long run. Despite this, many investors and financial professionals still question the merits of passive investing. This skepticism persists even though passive strategies, particularly index funds and ETFs (Exchange-Traded Funds), are supported by a vast amount of data.
Why does this happen?
What are the psychological, historical, and market-based reasons that lead people to doubt the efficacy of passive investing? In this blog, we will explore these questions and provide insight into why passive investing, despite the evidence, remains a debated topic.
1. The Psychological Bias of Control
One of the primary reasons why people question passive investing is related to human psychology. People have an inherent need to feel in control, particularly when it comes to their finances. Passive investing, by its nature, involves buying and holding a diversified portfolio, often tracking a market index, without any significant decision-making required after the initial investment. This lack of control can make people uncomfortable, as they may feel that by doing nothing, they are missing out on opportunities to "beat the market."
Active investing, on the other hand, offers the illusion of control. Investors can select individual stocks or work with fund managers who claim to have special insights or skills to outperform the market. The appeal of being able to react to market trends, news, or economic events gives investors a sense of agency. The idea that an expert, armed with information and analytical tools, can outperform a simple market index is hard to let go of for many people.
2. The Lure of Outperformance
The promise of outperformance is one of the most compelling reasons why investors question passive strategies. Active fund managers often claim they have the expertise to identify mispriced stocks, time the market, or exploit inefficiencies in a way that passive funds cannot. And indeed, in the short term, some managers do outperform the market. This creates a narrative where outperformance seems achievable, and the allure of beating the market becomes too tempting for some to ignore.
However, the data shows that consistent outperformance is incredibly rare. Numerous studies, including the well-known SPIVA (S&P Indices Versus Active) report, show that the majority of active managers underperform their benchmarks over the long term. For example, in the 2022 SPIVA report, over 80% of U.S. equity managers failed to outperform the S&P 500 over a 10-year period. The underperformance is often due to higher fees, transaction costs, and the difficulty of consistently timing the market or selecting the right stocks.
Even so, the belief in outperformance persists. This can be attributed to the human tendency to focus on short-term success stories or anecdotal evidence, while discounting the long-term data.
3. The Role of Financial Media
Financial media plays a significant role in perpetuating doubts about passive investing. Media outlets, by their nature, thrive on stories that capture attention, and the idea of a fund manager or individual investor making a bold, successful bet on a stock or market movement is much more engaging than a story about a passive fund steadily matching market returns over the years.
The financial press often highlights active strategies and the personalities behind them, reinforcing the notion that active investing is exciting and rewarding. The market itself, with its constant ups and downs, provides endless material for active managers and pundits to make predictions or offer hot takes. For passive investors, the advice often boils down to "do nothing," which isn’t nearly as engaging.
As a result, investors are constantly bombarded with stories of active managers who have outperformed over short periods, or who claim to have insights into the next market trend. This media bias can create a distorted perception, leading investors to believe that passive investing is too simplistic or that they are missing out by not engaging in more active strategies.
4. Behavioral Pitfalls: Loss Aversion and Recency Bias
Behavioral finance has long recognized that emotions play a significant role in investment decisions, often to the detriment of investors. Two cognitive biases stand out when it comes to questioning passive investing: loss aversion and recency bias.
Loss Aversion: This refers to the tendency of people to prefer avoiding losses over acquiring equivalent gains. In the context of investing, this means that people feel the pain of losing money more acutely than the pleasure of making money. In periods of market downturns, passive investing can feel especially painful, as investors have no way to react or mitigate losses. Active managers, by contrast, can at least claim to have the ability to navigate turbulent markets, even if the data doesn’t consistently support this claim.
Recency Bias: Investors tend to give disproportionate weight to recent events when making decisions. During bull markets, passive investing often looks appealing because market indices are performing well, and passive strategies easily capture those gains. However, in bear markets or periods of volatility, the appeal of passive investing can quickly diminish. Investors may question the wisdom of holding a broad market index when it’s experiencing significant losses, leading them to seek active strategies that promise to minimize risk or capitalize on short-term opportunities.
5. The Active Management Industry’s Incentives
The financial services industry has a vested interest in promoting active management. Fund managers, advisors, and institutions often have more to gain from active strategies because they can charge higher fees and justify their expertise. The structure of many compensation models in the industry, from performance fees to commissions, encourages a bias towards active management.
This economic incentive leads to a constant push for active strategies in the marketplace. Fund managers and advisors may not only question passive investing themselves but also encourage their clients to do the same. The idea that a professional can add value through active management is deeply ingrained in the financial industry, and it’s often supported by advertising, marketing, and client-facing materials that highlight the potential for outperformance.
6. The Fear of Missing Out (FOMO)
In investing, as in life, the fear of missing out is a powerful motivator. When investors hear about others making large gains from specific stock picks, IPOs, or market timing, they may begin to question the wisdom of their more measured, passive approach. The stock market has historically delivered strong returns over time, but those returns can feel incremental compared to the stories of rapid wealth accumulation that emerge from speculative bubbles or concentrated investments.
This fear of missing out can lead investors to abandon passive strategies in favor of more aggressive, active ones in an attempt to chase higher returns. The cryptocurrency boom of the late 2010s and early 2020s is a prime example. Even as passive investors enjoyed steady gains from traditional assets, the astronomical returns reported in crypto markets led many to question whether a simple buy-and-hold strategy was too conservative.
7. Complexity in Market Conditions
Another reason why passive investing continues to face scrutiny is the complexity and volatility of modern markets. Many investors believe that certain market conditions, such as extreme volatility, low-interest environments, or rapidly changing geopolitical landscapes, demand a more hands-on approach. The argument is that passive strategies, which are designed to mirror the market, are less equipped to handle periods of disruption or irregularity.
For example, during the financial crisis of 2008-2009 or the COVID-19 pandemic, there was a surge in skepticism about whether passive strategies could provide adequate protection or recover quickly enough. Many investors felt that active management was better suited to navigate such unprecedented events, even though long-term data suggests that passive portfolios typically recover alongside broader market rebounds.
8. Niche Markets and Specialized Strategies
Another point of contention for passive investing is its limitation in niche markets or specialized investment strategies. While passive strategies have proven effective in broad equity and bond markets, some investors argue that certain market segments, such as emerging markets, small-cap stocks, or alternative asset classes, may require active management. In these areas, market inefficiencies are believed to be more pronounced, creating opportunities for skilled managers to outperform the index.
Additionally, some investors have specific goals that may not align with traditional passive strategies, such as ESG (Environmental, Social, and Governance) investing or impact investing. In these cases, investors may feel that passive strategies don’t adequately reflect their values or objectives, prompting them to seek out more tailored, active approaches.
9. Short-Term Focus vs. Long-Term Data
The long-term data supporting passive investing is compelling. Numerous studies show that over time, passive strategies outperform the majority of active managers, particularly when adjusted for fees and costs. However, many investors have a short-term focus. Market performance, economic conditions, and personal financial goals can all change rapidly, and investors often feel pressure to react to these changes. This short-term focus leads some to believe that passive strategies are too slow or unresponsive to adapt to new information.
While passive investing is designed to benefit from the market’s overall upward trajectory, it requires patience and a long-term perspective. Investors who are fixated on short-term performance may become frustrated with passive strategies and question whether they are truly the best approach for achieving their financial goals.
10. Conclusion: The Debate Persists, But the Evidence is Clear
Despite the skepticism, the data overwhelmingly supports passive investing for most investors. The consistent underperformance of active managers, combined with the higher costs associated with active strategies, makes passive investing a compelling choice for those looking to build wealth over the long term.
The reasons why people continue to question passive investing are rooted in psychology, financial industry incentives, media narratives, and behavioral biases. However, by understanding these factors, investors can better appreciate why passive strategies remain a sound approach, even in the face of ongoing debate.
In the end, passive investing is not about trying to "beat the market." If your adviser is not using a passive investing strategy with your portfolio then you need to ask WHY?
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