Why Passive Investing Works - And Why It's Unlikely to Stop Working

I believe that markets are largely efficient.

This doesn’t mean that they are always right, but it does mean they very quickly and accurately price in new information. This has been the case for a long time and even in the days of passive investing, there are enough experts hyper focused on their narrow corners of the market to quickly price in new information when it becomes available.

The good news is, we don’t have to compete with those guys. And the reason is because of the relationship between risk and return. There are certain fundamental risks that all investors take when they invest. Risk at its core is uncertainty about the future. Because there is uncertainty about the future, the price of investments are lower (or higher) than they would be if we perfectly knew the future.

This means that as the future unfolds and that risk, i.e. uncertainty dissipates, there is a tendency for the price of investment to increase (or decrease) to compensate for the newly reduced amount of uncertainty. When new information becomes available prices adjust.

The reason that adjustment tends to be upward is that over the long arc of history, the economy grows, new companies are formed, and profits increase. To imagine a world where the stock market doesn’t grow over the long run, we have to imagine a world where the economy has stalled for the long term, new companies cease being born, and profits cease to increase. I’m not saying it’s impossible; it just seems very unlikely anytime soon. And even if it were, short of a global catastrophe, surely there’d be an economy somewhere that is growing.

This long-term increase in price is called a risk premium; it’s the return you get for assuming a given risk. Think about it like this: in insurance you pay a premium to reduce your risk; the same thing happens in reverse when you invest; you receive a premium to accept risk i.e. uncertainty.

There are certain risks that for a long time have reliably paid a premium to investors. These are called “rewarded risks”. They go by different names but the thing they all have in common is that exposure to these risks is inherent, which is to say, you are exposed to them by virtue of the fact that you hold an investment. An example of this is the risk that something random, e.g. a global pandemic, causes the market as a whole to sell off. These risks apply to large swaths of the market or even entire markets at once. You can’t avoid these risks and if you’re looking for a return you don’t want to.

There are other risks too that are called “unrewarded risks”. These are risks that have not reliably paid a premium and it’s usually because they are not inherent to investing but instead relate to the unique circumstances of very particular investments. An example might be the risk of a particular company having a product recall or being sued.

Exposure to unrewarded risks is the result of undiversified portfolios of individual stocks.

The good news about unrewarded risks is that you can diversify them away, which by the way is why they are unrewarded. If they were rewarded and you could diversify them away, then you’d have a risk free portfolio that was generating greater than risk free returns which doesn’t happen.

The way I focus on rewarded risks is through the use of low cost Exchange Traded Index Funds or ETFs. You can think of ETFs as very similar to mutual funds with a few features that make them a little more tax efficient and less costly to own.

In this regard, I believe that the more an investor can reduce their fees in their investments, the better their returns will be. This is why I focus on low cost funds. Above all, there’s just not much of an advantage to choosing higher cost funds if your only aim is to collect those risk premiums we were talking about.

The funds I use cover asset classes such as domestic and international stocks, large and small companies, real estate, and various types of bonds. I try to keep the portfolios I use limited to a handful of funds. There’s no advantage to having dozens of funds as each fund typically contains hundreds or even thousands of individual investments.

At the end of the day, the goal is to generate a good risk adjusted return so that you can live the life you want without constantly worrying about the future. This is what passive investing can do.