Passive Investing – The Evidence, Part 4: Ultimate Diversification

About: This video is video #4 in a series of videos by Sensible Investing.

There’s a wealth of evidence supporting it – including the work of Nobel Prize-winning economists
And, studies have consistently shown that, when costs are factored in, passive investing produces better returns than active fund management.

Of course one of the golden rules of investing is not to put all your eggs in one basket.

And the cheapest and most effective way to diversify is to invest passively.

Why pin your hopes on the shares of a handful of companies when, for less money, you can spread your risk by taking a stake in the entire market?

Active fund managers like to give the impression their funds do spread the risk you’re taking.

But while index funds often hold hundreds or even thousands of stocks, a typical managed fund will hold only around 50.

So if you choose an active fund you’re opting for greater volatility – and you’re paying a premium for the privilege.

Active fund managers do offer more genuinely diversified investments. Recent years have seen a proliferation of so-called balanced, cautious and defensive funds, as well as funds of funds.

But the charges on these funds are even higher. Among the most expensive funds are what are called absolute return funds, which are supposed to provide the investor with some sort of return whatever happens – but in reality often don’t.

Not only does the passive approach offer ultimate diversification within a fund; it also allows an investor to buy an entire asset class.

There are index funds for virtually every type of asset, whether it’s European equities, corporate bonds or UK gilts.

And even when you put your money in riskier assets you’re still spreading you’re risk by investing in the whole market.

To find out how investing passively can help you reap the higher rewards of riskier assets while smoothing out some of the volatility, I visited Austin, Texas.

This is home to Dimensional, a passive investment company specializing in investing in small companies and so-called value stocks.

One argument often put forward by proponents of active fund management is that when asset prices fall, they do so across the board. True, the value of an index fund tracking the FTSE 100, for example, rises and falls in direct correlation with the index itself.

But despite the disappointing performance of equities since 1999, a passive investor would still be sitting on a sizeable profit if they had spread their investments – especially when dividends are taken into account.

On average, they’re also better off than if they’d put their money into actively managed funds.

And so, to that other golden rule of investing… Always take the long-term view.
So, let’s summarize…

Investing passively is the cheapest and most effective way to spread your risk.

Because their holdings are restricted to a relatively small number of stocks, active equity funds are more volatile than passive ones.

Active fund managers charge a premium for funds that invest in more than one asset class.

And, over the long term, once charges are taken into account, the passive investor will always fare better than the average active investor..

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