Last Updated on July 24, 2022 by The MediFi Guy
What is Passive Investing?
Recall our prior discussion of Market Indices in the post about Active Investing. Specifically the mention of the date “1970s” and how I said I would get back to it. Well back in the day when investing only consisted of speculation, a gentleman by the name of John C Bogle noticed something peculiar about stock market Indices.
Remember, an index can be thought of as an average that tracks the average change in the market over time. John C Bogle noticed that when he looked at the historical data of stock market indices, they tended to look like this:
Image source: <a href=”https://commons.wikimedia.org/wiki/File:S_and_P_500_daily_linear_chart_1950_to_2016.png”>Overjive</a>, <a href=”https://creativecommons.org/licenses/by-sa/4.0CC BY-SA 4.0 Creative Commons Attribution-Share Alike 4.0″>CC BY-SA 4.0</a>, via Wikimedia Commons
Image source: <a href=”https://commons.wikimedia.org/wiki/File:Dow_Jones_Industrial_Average.png”>Jashuah</a>, <a href=”https://creativecommons.org/licenses/by-sa/3.0″>CC BY-SA 3.0</a>, via Wikimedia Commons
What the late Mr. Bogle noticed was that whilst the stock market indices experienced many periods of ups and downs, overall they tended to always go up over time. He calculated that this average growth in the stock market index tended to be around 10% pa over time. He wasn’t the first person to notice this, but what differentiated Mr. Bogle’s observation from the others who had seen it as well (and allowed him to change the course of human history) was that he asked himself a question:
“Seeing as though the market index on average grows by 10% per annum, if I were to buy shares in every single company that forms part of the market index proportional to their weighting in the index, would my investment also grow at the same rate as the market index?”
To answer this question, this is exactly what Mr. Bogle did. He created an investment portfolio where instead of speculating on various companies as was the norm, he instead simply looked at the current makeup of the S&P 500 index and bought shares in all 500 companies that make up the index proportional to their weighting on the index. Based on his theory that by simply investing in a way that matches the index, he should earn the same growth as the index. He then started an investment company where he offered this new type of investment, called an Index Tracking Fund aka an Index Fund, for sale to the public.
As a result, for the first time in human history investors had an alternative to speculating. They now had the option of a new type of investment vehicle whereby they could simply invest in the entire stock market via an index fund in an attempt to capture the average market return. How did the world react to Mr. Bogle’s invention of the Index Fund?
They called him a madman
To quote from Wikipedia:
“Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly”. In the first five years of Bogle’s company, it made 17 million dollars. Fidelity Investments Chairman Edward Johnson was quoted as saying that he “[couldn’t] believe that the great mass of investors are going to be satisfied with receiving just average returns”. Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor’s 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market’s increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000.”
Essentially what happened was that the investing establishment at the time initially derided Bogle’s idea calling it foolish and claiming that it had no basis in reality, then later changed to claiming that even if it did no one would want an “average” return anyway since one could easily get higher than average returns by speculating. They thought the concept of an index fund was doomed to fail.
What actually happened, in reality, was exactly what Bogle had predicted. His index funds managed to grow at the exact rate of the market index that they were tracking. As a result, the index fund on average earned a return of 10%pa, whereas every other active investment portfolio would on average fail to consistently match the index over time let alone outperform it.
Investors took notice. The world took notice. And as years of data accumulated, the verdict became clear:
Passive Investing (the act of simply buying the entire market index, which does not require any research other than checking the current composition of the index and making sure your portfolio matches it thus incurring lower fees than active investing) produces a higher and more consistent rate of return over time than Active Investing.
In summary, Passive Investing refers to investing in Index Tracking Funds aka Index Funds. Which are funds that contain shares in every company included in the stock market index. And as a result matches the average growth of the stock market, which historically tends to always go up at a rate of roughly 10% per annum making index funds the safest and most reliable means of achieving consistent gains.
Here is an example to illustrate the power of an index fund.
Let’s say you live a lifestyle where your monthly expenses total R40 000, and you would like to continue living a R40 000 per month lifestyle after retirement.
Using the 4% rule to determine how much money you need to be able to retire:
R40 000 × 300 = R 12 000 000 needed at retirement.
Now let’s assume that you intend to work the standard 40-year working career (age 25 to 65) and throughout your career, you were to invest R3000 per month in a Stock Market Index Fund. Assuming that historical trends continue and your investment grows at an average rate of 10% per annum, how much money would you have by the time you retire?
At the end of your working career, you will have R 16 900 000.
Out of that total of R16.9 million, you would have only contributed R 1.4 million of your own money. The remaining R15.5 million is pure interest.
So all you needed for retirement was R12 million. Instead, you got R16.9 million. Your retirement is secure.
So is that it? Is that what investing basically comes down to? Just buy and hold a stock market index fund until retirement and you’re set? Is it that simple?
Pretty much, yes. A lot simpler than you thought, huh? That’s basically the gist of things but it does come with a few critical caveats to understand.These caveats and the concepts they entail could easily destroy your wealth if you don’t know about them. Those concepts are:
Volatility
Asset class correlation
Investment time horizons
We will elaborate on all of these concepts in forthcoming posts.
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