Passive Investing and Good Advice — A Powerful Combination

For many reasons, indexing is one optimal way to invest. One of the benefits of indexing is the potential freedom from emotional swings that encumber active investors — swings that hamper most investors’ ability to earn the markets’ superior returns while they simply invest and relax, enjoying a peace of mind IFA refers to as “Tradeless Nirvana.”

This important point is illustrated in the following chart, which shows that average fund investors who invest primarily in actively managed funds (the blue bars) capture on average only 36.75% of the actual returns delivered by a fund. This underperformance may be easily attributed to what IFA refers to as the “emotions of active investing.”

Meanwhile, indexers without passive advisors (purple bars) do much better than active investors at capturing a higher percentage of fund returns, the result of a less active approach. However, indexers without passive advisors also fail to capture the full returns of the market. The average passive investor earns only an average of 82.7% of a fund’s return. How can this be? It may be explained by a failure to rebalance asset allocations during market turbulence, or even the inability to stay invested during rocky markets.

In sharp contrast to average fund investors and indexers without passive advisors, DFA fund investors (green bar) capture all of the fund returns and then some — 109% of the fund returns. According to Morningstar, this exceptional outcome is a result of the “very smart behavior” that is practiced by the passive advisors who utilize sophisticated investment knowledge1. These knowledgeable advisors encourage their clients to stay invested and rebalance through market turbulence. Such behavior may enables these investors to maximize their ability to capture returns and provides sound justification for the right advisor.

1Sanjay Arya, John Coumarianos, Pat Dorsey, Russel Kinnel, Don Phillips, Tricia Rothschild, “Morningstar Indexes Yearbook,” Morningstar, Inc., vol. 2 (2005)

Figure 1 (Direct Link)

Watch Tom and Mark talk about the value of a passive advisor:

Tom Cock interviews Mark Hebner on the value of a passive advisor. People are hardwired to make poor decisions when it comes to money, which leads investors to earn returns far below the market. There can actually be an addictive nature to investing, but a quality passive advisor can help an investor manage emotions and avoid outcomes of bad behavior. Hebner discusses a study that shows how people flow in and out of investments at the wrong time, leading investors to earn less than the fund itself. He also discusses a key chart that displays investor success at capturing fund returns with and without a passive advisor. Future topics are presented: Investing Instruments, Science Meets Art, the 401 (k)orner, and Pillars of Finance.