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Congratulations, you’re starting to get the hang of the stock market and what makes investing so powerful. You’ll even be ready to open your brokerage account and start buying stocks by the end of the next module, but we want to make sure you avoid one of the biggest pitfalls in investing first.
One of the most dangerous terms you’ll hear when you start building a portfolio is “passive investing.” Passive investing is simply matching the market’s returns by owning low-cost ETFs, the funds we covered in Lesson 1.
Investing legends from Jack Bogle to Warren Buffett sing the praises of ETFs and passive investing. If you’ve researched the stock market before, you’ve likely heard one of these expressions:
“You can’t beat the market, so just own ETFs instead.”
“Investing in ETFs is much safer than buying individual stocks.”
“You can’t afford to risk your retirement savings on stocks.”
But this conventional wisdom isn’t just dead wrong; it’s actually dangerous. While it’s quickly becoming America’s preferred investment strategy, it could be a costly mistake.
ETFs work like this: They hold a basket of stocks that track the performance of a specific index. You can own ETFs that track the Nasdaq, the Dow, large-cap stocks, mid-cap stocks, or even specific sectors like technology.
They’re popular because they’re easy to buy (just like a stock), they let you get exposure to multiple stocks with one purchase, and they’re low-priced. Since fund managers don’t need to do any work besides making sure the ETF’s holdings match the index it’s tracking, ETFs charge very small fees compared to actively managed funds.
And passive investing with ETFs offers investors average market returns, which as we mentioned earlier, will make you more money than just parking your cash in a savings account.
So for many, matching the returns of the S&P 500 with little cost sounds like a no-brainer. That’s why Americans are piling their money into these passive investments. The amount of money in ETFs has ballooned 2,500% since 2000. There are now more than 1,500 ETFs trading on U.S. exchanges thanks to that surging demand. Brokerage firms from Vanguard to TDAmeritrade are even competing for clients by offering free ETF trading.
And we’ve certainly recommended ETFs before, as part of a bigger investing strategy.
But there is a unique flaw in this type of investment decision, especially when a significant portion of your money is in ETFs.
Too many investors feel that it's "safe" to passively invest. They think they'll come out ahead if they just buy and hold for the long haul.
But it’s dangerous for investors to assume that passive investing is somehow safer than traditional portfolio management.
Wall Street has a herd mentality, and there is a collective message being broadcast to the masses that it's going to profitable long-term to buy and hold low-cost index funds. But that’s highly contingent on timing the market.
In reality, you could lose big, depending on when you enter the market. When the market drops, average market returns can mean big losses, like the 50% plunge the Dow took between 2007 and 2009.
Since June 1999, the Dow has gained less than 200%, despite two bull market runs, including the longest bull market ever.
In reality, over the past two decades, the market has only produced a 4% annual return. That’s just not the kind of performance you need to meet your retirement goals.
And it’s hardly safe. If you were nearing retirement in 2007, owning ETFs could’ve added another decade to your work life.
While ETFs will provide you no cover during the next market pullback – and could even make it worse – there’s an even more damning problem behind their popularity. It’s also an opportunity for people like you who are taking the time to learn what makes a stock worth owning.
As Howard Marks, the co-founder and chair of Oaktree Capital Management, told his clients, “Active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’ decisions.”
In short, ETFs merely mimic the market, and market prices are set by what active investors are willing to pay for stocks.
And while passive investors have been free-riding on the research and analysis of active investors, the party will quickly coming to an end.
As Marks explains, once the majority of stocks are managed passively, “prices will be freer to diverge from ‘fair,’ and bargains (and over-pricings) should become more commonplace.”
Did you catch that? Passive investors are distorting the market, but it’s in our favor.
That’s why the most successful investors generally don't have payroll deductions set up to go into ETFs. Instead, they wait until market conditions are right and then buy shares in high-quality companies at discount prices. Then, they hold onto those shares for the long term.
It's this type of investing that has allowed Warren Buffett's company, Berkshire Hathaway Inc. (NYSE: BRK.B), to outperform any returns earned by passive investors. Assuming a passive investor entered the market in 1999, they would have barely earned 100% returns over 20 years. Knowing what and when to buy and sell, Buffett was able to give his shareholders quadruple returns over that same period.
It is this type of investing that would be the difference between reaching your retirement goals and having to remain in your job for another five years.
And by taking the time to research stocks, you could match these gains on your own.