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Fiduciary Focus: Active vs. Passive Investing (Part 5)

Myths about passive investing don't jibe with realities.

W. Scott Simon, 06/30/2005

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Given my suggestion in last month's column that passive investing is the "default" standard for modern prudent fiduciary investing, I though it might be worthwhile to dispel some widely accepted myths of passive investing to help fiduciaries in their understanding.

Myth: Passive investing is risk-free.

Reality: Nobel Laureate Harry Markowitz observes: "Risk is risk." Since there's no guaranteed safe way to reap the rewards of investing in financial markets, passive investing is no panacea for escaping investment risk. Passive investing is, however, the best way to rid a portfolio of as much uncompensated risk as possible (and the only way of eliminating the risk of underperforming a given financial market).

But investing passively cannot eliminate the risk of losing money. No amount of diversification--whether done on an active basis or a passive basis--can reduce the compensated risk that's present in all investment portfolios. That's because such risk is inherent in all financial markets. The only way to avoid that kind of risk is to avoid investing.

Myth: Passive investing is investing just in S&P 500 index funds.

Reality: Many investors equate passive investing with investing just in S&P 500 index funds. When the stocks of the S&P 500 outperform some other well-known asset class such as small-company stocks, they seem to think that passive investing works. When those stocks underperform, many investors seem to think that passive investing doesn't work. The fact that the large-company stocks composing the S&P 500 underperform some other asset class, though, has nothing to do with the validity of passive investing. It just means that the stocks of that asset class failed to outperform those of the other asset class for the period in question.

Passive investing, then, means more than investing just in S&P 500 index funds. For example, passive investors can invest in funds tracking the entire U.S. stock market. Passive funds are also invested in small-company, midsize-company stocks, and emerging-markets stocks that represent discrete asset classes. Other passive funds provide the performance of asset classes reflecting specific investment styles such as "value" and "growth" stocks. Nor is passive investing limited to stocks. There are passive fixed-income funds that hold corporate bonds, Treasury bonds, or combinations of them with clearly defined standards of quality and maturity.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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