The benefits of passive investing are plain and simple

Warren Buffett is well known for his successes in investing, and this includes a staunch support of the passive approach, a lower-octane investment style where solid assets are held for a long period without regular adjustment. Both the passive and active approaches require the use of investing fundamentals – that is, an understanding of the factors that influence the value of assets over time, like macroeconomic trends and the financial health of companies and sectors. 

“When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever,” Buffett quipped in a 1988 letter to shareholders. The line has become an oft-repeated nugget of passive investment wisdom, and typifies the approach neatly; in the passive style, rapid portfolio manoeuvres are eschewed in favour of patiently holding reliable investments for the long term. While “forever” is not meant to be taken literally, it helps to illustrate the thinking behind passive investing. More than any other investment style, the passive approach calls for patience, confidence in fundamentals, and a steely nerve – as many investors know, hanging on to a particular asset during volatile periods can be a frightening experience.

However, if you can face down those periods of market stress – and if you have a thorough grasp of your investment fundamentals – the benefits of passive investing are plain, as Buffett suggests. The S&P 500 Index, for example – essentially the most popular investment in the world, based on index funds – has risen by more than 180% over the last decade. The investor who bought an S&P 500 Index tracker in 2013 and did not touch it for those 10 years is likely to have been rather pleased with his or her results. There have, of course, been many brutal trading days during that time – March 2020 alone saw three of the S&P 500 Index’s worst recorded days in history, as Covid-19 sent shockwaves through stock markets. However, the investor who baulked at the month’s turmoil and sold out may have missed a similarly substantial recovery, as the S&P 500 hit record highs a few months later in September.

Time in the market beats timing the market

Naturally, active investing, a higher-risk style in which investors seek out individual stocks they think (or hope) will outperform the broader market, trading frequently to take advantage of price movements, does have advantages of its own. Though active investors are exposed to larger – potentially ruinous – risks, their gains can rise far above those enjoyed by passive investors. Choosing the right investment at the right time can produce ‘market-beating’ returns, and there are a number of examples of savvy active investors making dramatic plays of this type. George Soros, another enormously successful investor, is famed for his highly speculative tactics: in 1992, believing that the value of sterling would soon fall, he racked up a series of massive bets against the UK currency over several months. His assessment proved correct, and he made a £1 billion profit when sterling eventually dropped in value. Of course, had Soros bet wrong, his losses would have been eye-watering.

However, ‘timing the market’ as Soros did in 1992 is easier said than done; and for most investors, such gambles are unlikely to pay off. The riskier nature of active investing can lead to serious losses in periods of market crisis – episodes where large numbers of investors lose money, even if a fortunate few who made bets in the right direction reap a profit. Spikes of intense volatility have less of an impact on the passive investor – a rough month or even year does not mean calamity for the long-termist, provided they can hold their nerve. “Time in the market beats timing the market – almost always,” wrote investment analyst Kenneth Fisher in an article for USA Today in 2018, giving passive investors a useful catchphrase.

Buffett himself notoriously made a $1 million wager on the ‘time versus timing’ debate in 2007, issuing a challenge to the hedge fund industry. A simple S&P 500 Index fund, Buffett said, would outperform the active stock selection of hedge fund managers over a 10-year period. Protégé Partners agreed to the bet – over the next decade, the firm vied against the power of passive investing. Eventually, the hedge fund surrendered, having achieved a return of $220,000 versus the S&P 500 Index fund’s $854,000. While Protégé did made a positive return, it was dramatically smaller than that of the broader market.

Ultimately, sticking with a long-term investment goal takes discipline and confidence, especially amid the day-to-day noise of economic news. Even if you have resolved to hold a particular asset for a number of years, a few days of negative reporting are enough to dent the confidence of any investor. If you find yourself struggling to maintain these long-term relationships, there are a few moves you can make to support your passive investing strategies.