Passive Investing: Cheap, Lazy, Yet Smart

Kurt von Hammerstein-Equord, one of Germany’s peacetime Chiefs of the Army High Command before the Nazi regime came to power, was credited with an eccentric classification scheme for his subordinates:

“I divide my officers into four groups. There are clever, diligent, stupid, and lazy officers. Usually two characteristics are combined. Some are clever and diligent — their place is the General Staff. The next lot are stupid and lazy — they make up 90 percent of every army and are suited to routine duties. Anyone who is both clever and lazy is qualified for the highest leadership duties, because he possesses the intellectual clarity and the composure necessary for difficult decisions. One must beware of anyone who is stupid and diligent — he must not be entrusted with any responsibility because he will always cause only mischief.”

According to him, people can be categorized as either “Clever” or “Stupid” and simultaneously, “Diligent” or “Lazy”.  And from his experience, the leaders with the combination of being both “Clever” AND “Lazy” have proven to be the most effective and reliable.

We’ll extend Hammerstein-Equord’s philosophy to our investing and let our money work in our sleep with relatively little effort.

Difference Between Passive vs. Active Investing

When you picture a crowded group of Traders running, yelling, waving, etc. on the floor of the New York Stock Exchange or a day trader looking at 10 different monitors, we’re referring to Active Investors.  Active Investors will buy and sell their investments on a regular basis hoping to achieve a better than average rate of return.  While many clever Active Investors will manage to beat the market, most will end up underperforming the market in chasing this dream.  Due to the fundamentally sporadic nature of financial markets, diligence and superior analysis offer no guarantee of higher returns.  And severe losses, which increase in probability when you invest actively, are extremely difficult to recover from.  (For example, you’d need to make a return of 1000% in order to recover from losing 90% of your portfolio’s value.)

Passive investing, on the other hand, involves buying an Index Fund that approximates the average performance of the market as a whole.  In the old days, you’d have to buy 30 to over 100 stocks to approximate the Total Stock Market.  Now, thanks to index Mutual and ETF funds, you can save a ton of commissions and only pay a nominal for investing in the fund.

Don’t Be Afraid of Being Average

Odds are, you won’t beat the market by a significant margin.  Because the vast majority of participants in the US equity markets are professionals, their aggregate (average) performance will be similar to the performance of the S&P500 or the Total Market Index.  While Active Investing makes you feel you’re in control, in reality, you have virtually no control over the performance of any stock or bond you buy.  Besides, you can buy either of these indexes in a single ETF fund for a negligible commission and management fee as previously mentioned.

So what does this mean?  It’s possible to achieve average investment performance simply by buying an index fund without knowing much about investing in the first place!  Contrast that to many other disciplines, for example, being a doctor.  You’ll need years of medical school AND experience in order to become an “average” doctor.  Or lawyer.  Or singer.  Or computer programmer.  Etc.

So How am I Supposed to Invest Anyways?

Now, investing isn’t as easy as buying an S&P 500 index fund and calling it a day but it doesn’t need to involve complexities like timing the market, picking a dozen of different stocks, etc.  In future posts, I’ll explore the idea of Asset Allocation which is essentially the art of deciding what proportions of your portfolio you should devote to distinct asset classes (i.e. stocks, bonds, commodities, etc.)  And each asset class can be directly invested in using its respective index funds instead of buying its constituent components individually, which means your portfolio should typically have only around 2 – 8 entries total.  In the meantime, if you like to explore Asset Allocation on your own, Bogleheads has a great repository of advice.