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The Myth of Passive Index Investing

By Dan Ferris, editor, Extreme Value
Monday, September 24, 2007

Over the years, I've become biased toward holding rather than selling, because selling is the mistake I make most often. I don't mean selling too soon or too late, or at the wrong price. I mean selling, period.

If I'd merely held every stock recommended in my advisory, Extreme Value, losers and all, the portfolio would have done better. The compounding effects of the winners would have more than made up for the few losers we've had.

Today, I bring you more evidence that, if you think you can actively manage your way to a fortune, you should think again. Focus on stocks you can hold passively for decades.

I recently learned of a study that confirms that stock indexes are too actively managed. Let's be clear that I'm talking about the indexes themselves, not the index funds that actually buy the index components. It turns out that stock indexes like the S&P 500 are actively managed... much to the chagrin of the would-be passive investors who buy into the funds.

Here's how it works... An index will drop a stock if it crashes and add one that's perhaps become large enough and which the indexers feel is "more representative" of the sector. The indexers will tell you it's more complex than that, but that's what it amounts to.

The study I'm talking about is called Index Rebalancing and Long-Term Portfolio Performance, by Jie Cai of Drexel University and Todd Houge of the University of Iowa. Cai and Houge did a study of the Russell 2000 Index, composed mainly of small-cap stocks. The authors report that:

We examine the long-run performance associated with changes to the small-cap Russell 2000 index from 1979-2004... We show that a buy-and-hold index portfolio significantly outperforms the annually rebalanced index by an average of 2.22% over one year and by 17.29% over five years.

Not only did the authors discover that index rebalancing hurts performance, but stocks taken out of the index end up performing better than the index itself. To increase buy-and-hold returns, in other words, you should put deleted stocks back into your buy-and-hold portfolio.

Of course, even after taking all of this into account, most investors would still do much better buying a low-cost index fund than they would by actively managing their own money. Very few people have the ability to buy the right stocks at the right prices and hold them long enough to compound their money via tax-deferred capital gains. Most people are scared of buying stocks when they should be greedy about it, and they're greedy when they should know better.

Be very careful of the fatal conceit of thinking you can turn over a few dozen positions a year and do anything but finance your broker's yacht. The constant turnover makes you feel like you're doing something exciting, like you're taking charge of your destiny. But the something you're doing is destroying wealth, and the destiny you're pursuing ends in the poorhouse.

The ultimate shareholder benefit is the effect of compounding over time. And time, the great intangible that consumes us all, is the one thing people have the most trouble managing. That's why I'm always saying that the best and easiest advantage you can get over other investors is a longer holding period, patience, the long-term perspective, or the use of time arbitrage. It's all the same. Stop being so active with your money, and just let it sit and compound.

All you have to do is be patient, and you win – i.e., get rich – practically by default. Warren Buffett once said that it's not that hard to get rich, provided you're not in too much of a hurry. He also said that lethargy bordering on sloth is the cornerstone of his investing style. That's why I rarely sell stocks in my letter.

Aesop was right. Slow and steady wins the race.

Good investing,

Dan Ferris

Market Notes


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-Sean Goldsmith

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