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Recently I talked with a cou­ple about our approach to invest­ing. The hus­band had spent a lot of time on it and grasped all of the nuances. The wife said she was a lit­tle befud­dled but after sev­eral hours of con­ver­sa­tion, exam­in­ing charts and tables of num­bers, she finally asked: If this is so good, why doesn’t every­one use it?

I fum­bled around for an answer but couldn’t come up with any­thing com­pelling. It’s a good ques­tion because most peo­ple don’t use pas­sive invest­ing even though the expe­ri­ence of the last thirty years over­whelm­ingly endorses this approach.

Before we get back to the ques­tion, let’s briefly explain pas­sive invest­ing. Until thirty years ago, every­one was an active investor. That is, they tried to pick the best stocks, bonds and mutual funds and hoped to come out ahead of all the other mar­ket par­tic­i­pants. But start­ing in the mid-1950s, aca­d­e­mics began to the­o­rize that investors doing this were sim­ply engaged in an expen­sive and ulti­mately futile effort, chas­ing this dream and usu­ally falling far short of where they should be.

An Invest­ing Revolution

Even­tu­ally this the­o­riz­ing and a gigan­tic bear mar­ket spawned the begin­ning of the pas­sive invest­ing rev­o­lu­tion in the 1970s. To the extent that peo­ple know pas­sive invest­ing at all, they asso­ciate it with index funds as pop­u­lar­ized by John Bogle and the Van­guard Group. In keep­ing with the lethar­gic name, in this approach, instead of try­ing to “beat” the mar­ket, investors keep costs low and merely try to come as close to the broad stock mar­ket returns as possible.

While this strat­egy may not sound excit­ing, think again. This sim­ple strat­egy over time beats nearly every­one – at least 99 per­cent of investors. This includes most mutual funds, nearly all of those smart peo­ple you see onTV and read in the news­pa­pers, the vast major­ity of those peo­ple fran­ti­cally yelling on the floor of the New York Stock Exchange and nearly all of your neigh­bors. When peo­ple talk about the stock mar­ket, they gen­er­ally empha­size their win­ners, but the real tally is often a quite dif­fer­ent picture.

How can this be? You might ask. With all these smart peo­ple work­ing so hard and lis­ten­ing to the best minds, why can’t they beat this sim­ple, mind­less, mechan­i­cal formula?

The main rea­son is that there are so many smart, well informed and hard work­ing peo­ple chas­ing this same dream. Yet another rea­son is that peo­ple are human and ill equipped for this par­tic­u­lar task. They are emo­tional and ener­getic and opin­ion­ated and they can only focus on a lim­ited num­ber of things at one time. All of these things lead to crit­i­cal mis­takes that dimin­ish performance.

Finally, peo­ple can’t leave well enough alone. Nobody wants to merely beat 99 per­cent of other investors. They want to beat them all. In the process, despite their ini­tial hopes, they end up inflict­ing sig­nif­i­cant finan­cial dam­age on them­selves and often an emo­tional toll as well.

While the sim­ple mechan­i­cal for­mula works sur­pris­ingly well, we believe that using these same insights, there are ways to cap­ture sig­nif­i­cantly bet­ter per­for­mance with­out increas­ing risk expo­sure. The orig­i­nal index­ers focused on stan­dard indus­try bench­marks. The old­est and biggest is the Stan­dard and Poor’s 500, which con­sists of 500 of the biggest and most impor­tant U.S. stocks. The prob­lem now is that too many peo­ple mimic the same few indices and so it’s got­ten intensely com­pet­i­tive. When an “index” reshuf­fles its mem­ber­ship, every­one has to buy or sell at the same time no mat­ter what the cost. Step­ping out­side this process is a big benefit.

A Sec­ond Revolution

In response to these prob­lems, other pas­sive investors have cre­ated their own col­lec­tions of stocks and by build­ing in a mod­est degree of flex­i­bil­ity find that the pay­off is huge. They may also tar­get spe­cific seg­ments of the finan­cial mar­kets. This is much harder than it sounds but if it is well exe­cuted, this inno­v­a­tive approach makes a big dif­fer­ence. This leap in pas­sive invest­ment the­ory and prac­tice is suf­fi­ciently large as to con­sti­tute a sec­ond rev­o­lu­tion in pas­sive investing.

A related devel­op­ment in pas­sive invest­ing is an increased empha­sis on invest­ing over­seas. Most U.S. investors focus too heav­ily close to home – they need to be more adven­tur­ous and spread out around the globe. While the U.S. remains the pre­em­i­nent eco­nomic power, the rest of the world is gain­ing on us. Many nations are grow­ing much faster than the U.S. and given our already large and suc­cess­ful econ­omy, the rel­a­tive growth is likely to endure.

Finally, pas­sive invest­ing requires patience and does not fur­nish the excite­ment that active invest­ing does. There are no sto­ries to tell, no tri­umphs to cel­e­brate. The only thing excit­ing about pas­sive invest­ing is the results. By tak­ing a small sliver of thou­sands of stocks world­wide and hew­ing to this sys­tem for many years, an investor has the best chance of reach­ing his goals and pre­serv­ing and accu­mu­lat­ing wealth.

It’s dull, it’s bor­ing, it requires sit­ting still and a lot of humil­ity but in the end pas­sive invest­ing works and what’s the mat­ter with that?

Larry Lux­en­berg, 2/2008

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The views and infor­ma­tion con­tained within this arti­cle are pro­vided for infor­ma­tional pur­poses only and are not meant as invest­ment advice. They rep­re­sent the author’s cur­rent good-faith views at pub­li­ca­tion time and are sub­ject to change with­out notice. As with any strat­egy, it is impor­tant for an investor to fully under­stand the strat­egy prior to invest­ing; seek­ing advice from a pro­fes­sional advi­sor can be a good place to start.

The infor­ma­tion that is pro­vided on herein has been com­piled to the best of our abil­ity. How­ever, the authors makes no war­ranty of any kind, expressed or implied, and will not be held respon­si­ble, or liable for errors, or omis­sions result­ing in any loss or dam­age caused or alleged to be caused, directly, or indi­rectly, by infor­ma­tion con­tained in 3 factor’s publications.

Links to other web sites are pro­vided as gen­eral infor­ma­tion sources for the reader. 3 factor has not for­mally eval­u­ated the infor­ma­tion pro­vided via these sites and inclu­sion of these links does not con­sti­tute an endorse­ment of any orga­ni­za­tion. The links pro­vided are main­tained by their respec­tive orga­ni­za­tions and they are solely respon­si­ble for their con­tent. Trade­marks are the prop­erty of their respec­tive owners.

3 factor has con­ducted exten­sive analy­sis con­cern­ing port­fo­lio per­for­mance. See “impor­tant dis­clo­sure” for details and dis­claimers regard­ing our state­ments con­cern­ing per­for­mance, and the var­i­ous assump­tions we have made in our analy­sis.