Passive Investing is a Parasite on The Market

Passive investing continues to gain more traction as more people seem to be buying into it. Lots of money managers and those in the finance world continue to tout the effectiveness of passive investing. However, is it as effective in the long-term as many people think?

“We don’t have to be smarter than the rest, we have to be more disciplined than the rest.”

Warren Buffet

What is Passive Investing?

Passive investing is an investment strategy to maximize returns by minimizing buying and selling.

Index investing in one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon. In other words, the goal of passive investing is to match the performance of the market.

Why has Passive Investing Gained So Much Attention?

There are several reasons why passive investing has become popular in recent years:

  • It’s Cheap: Passive investing tries to reduce the amount of buy/sell orders that happen. A common passive investment practice is to buy index funds or low-cost ETFs that have marginal management fees.
  • It’s Easy: Passive investing takes minimal research and minimal tracking of the market. It only requires occasional re-balancing.
  • It’s Consistent: Passive investing aims to mirror the returns of the market. Therefore, returns are consistent and reflect market behavior.

For more information on why passive investing has grown so much from a psychological perspective, check out Why You Are Under-performing The Market.

Parasitic Comparison

A great comparison to a passive investor is a parasite. Before you get offended, let us explain…

A parasite, on an elephant for instances, attaches itself and sucks the blood of the elephant while contributing nothing. If there is only one parasite, it is not a big deal. However, when life is easy and fruitful (like it is for the first parasite) news spreads fast.

But what happens when there are a lot of parasites? Eventually, they overwhelm the elephant and cause it to die.

Passive investors play much the same role in the investment landscape. They buy index funds, then sit back and enjoy the ride. They don’t contribute to price discovery and market research.

The Problem

The problem with passive investing is that it’s a parasitic strategy. It works until it doesn’t work.

As more and more people start to invest passively, they are sucking the blood out of the market. As long as there are more active investors than passive investors, the passive investor is just fine.

But what if passive investors outnumber active investors? When passive investors (parasites) outnumber active investors, the market (elephant) dies.

The amount of money being added to passive investing continues to grow. Since 2009, $2.5 trillion has been added to passive strategy funds, whereas, $2 trillion has left active funds.

Active investors are the ones that contribute to price discovery, liquidity, and determining the true value of the underlying business or company. Active investors can also act as a sort of brake for the markets.

If markets are climbing, the active investor might see it as a bubble, step aside, and move to cash. On the other hand, if the market is declining, they may see value or potential growth in certain companies, and start buying.

In either situation, the active investor acted as a brake. They were the catalyst to stop the market from increasing or decreasing irrationally.

Conclusion

The passive investor has enjoyed some profitable gains over the past decade. However, there could be quite a shock headed their way when the market breaks like it did in 2008, 2000, 1998, 1994, etc.

We are a decade into the upside of a stock market cycle that historically only lasts five to seven years. You could say we are overdue for a downturn.

When the market does turn downward, it is reasonable to assume that typical investor behavior will kick in and individual passive investors will liquidate their holdings out of fear of loss.

The passive investment vehicle (usually ETFs) is structured to honor all sell orders by the end of each trading day regardless of price. As active investors disappear, who will be the buyer to fill these sell orders?

That is when active investors would normally step up and act as the break… But this time there might not be enough left to make a difference. As liquidity dries up, passive investment vehicles could be bid far lower than anyone expects and losses could be very significant for many.

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Sources:

https://dailyreckoning.com/free-riding-investors-set-up-markets-for-a-major-collapse-2