Passive investing through index funds is an increasingly popular choice among Indian investors today. Most of us now understand the basic approach behind passive investing. We also have a much better understanding of index funds as a product category. But this alone is not enough to understand and apply passive investing the right way. We also need to understand the concepts which the passive approach is based on. Therefore today I am going to talk about the core concepts behind passive investing. I will also show how each concept ties into the passive approach.
The foremost concept behind passive investing is the distinction between enterprising and defensive investors. Benjamin Graham, a pioneer of modern investing first made this distinction. Enterprising investors are those who focus on researching and selecting securities on their own. They choose this route because they are willing to devote the time and knowledge required for doing so. They therefore expect to beat the return offered by the market.
Defensive investors lack the time and knowledge required for research and selection. They aim to put their portfolios on autopilot beyond a certain point. They are happy to accept market returns. They hence focus more on basic principles like asset allocation.
The level of time and knowledge required for successful enterprising investing is similar to that of a professional investor (for instance mutual fund managers, portfolio managers and so on). Most of us lack the ability or willingness to put in that kind of effort. It has been proven by hard research data that most enterprising investors fail to beat the market. Therefore the majority of us are better off being defensive investors. And the most viable option for defensive investors would be passive investing through index funds.
The Random Walk theory is another key contributor to the passive approach. It states that the current market price of a security is the best forecast of its future price. This means past trends in price movements cannot be used to draw an inference on future price movements. Future price movements are likely to take a random and unpredictable path. This is similar to the steps of a drunkard. And therefore the name Random Walk theory.
Given that future price movements are not predictable, it would be unwise to try predicting and profiting from them. Most investors should therefore follow the passive approach by holding a broad market index fund.
The concept of efficient markets also lends itself to the passive approach of investing. The concept is born from the Efficient Market Hypothesis (EMH). The EMH states that all available information about a stock is automatically factored into its market price. It therefore postulates that there is no scope for investors to beat the market if markets are fully efficient.
The veracity of the notion of fully efficient markets is always fiercely debated. But it is widely accepted that most markets are efficient most of the time. Indian markets are a lot more efficient than they were 2-3 decades ago. Indian investors would therefore be better off behaving as if markets are fully efficient. And the best way for investors to operate in highly efficient markets is to use index funds.
Another important explanation in favour of passive investing is a concept known as The Arithmetic Of Indexing. The concept focuses on the impact of investment costs on investment returns. It states that if investors were to pick stocks from a particular index, then before costs, their return will equal the return of the equivalent index fund. But the costs associated with active management are significantly higher relative to passive management. Therefore post cost, the returns on money invested in active management strategies would lag the return on money invested in index funds.
This shows that the observation that indexing works is not just a theoretical notion. It is a matter of mathematical fact.
It is very well understood that building portfolios with negatively correlated assets lowers risk. But risk can also be lowered through adequate diversification within an asset class. Effective diversification within an asset class is achieved by holding a portfolio of securities that represents the broad market for that asset class. So the most viable way for investors to adequately diversify their portfolios would be to hold a broad market index fund at low costs.
There is hence enough conceptual and mathematical evidence to show that passive investing works. Investors must understand these concepts and evidence clearly. It would help them appreciate the essential benefits of passive investing. It would also give them a holistic understanding of the passive approach. It is only after fully understanding these concepts that investors must adopt the passive approach.
To understand how to build equity portfolios using the passive approach have a look at my earlier article, The Process Behind Constructing Passive Equity Portfolios. To understand how to build low cost, well diversified portfolios have a look at my earlier article, Low Cost, Highly Effective Portfolios.