What is index or passive investing?

What is index or passive investing?

Index investing, also known as passive investing, rests on a simple but powerful truth: for every investor who beats the market and earns above-average returns, there is another who earns below. For the vast majority of non-professional investors, trying to win that game is a losing proposition, which is why indexing makes so much sense.

In this video, Meir Statman, Professor of Finance at Santa Clara University and one of the world's best-known experts on behavioural finance, explains what index investing is and why it suits ordinary investors so well. Statman, author of "Finance for Normal People," argues that people are far more rational about money than they are often given credit for. Most of us have perfectly normal wants: to be comfortable rather than poor, to look after our children, to gain status, to stay true to our values, and sometimes simply to play games in the market. The key, he says, is learning to tell the difference between a genuine want and a costly error.

You'll learn how to identify what you really want from investing and how to satisfy those wants without falling into expensive traps. Statman uses hedge funds as an example: they can confer status precisely because they are reserved for the wealthy, but the returns to investors, as opposed to their managers, are often poor. If status is the goal, he suggests, there are far cheaper ways to achieve it.

Statman is a strong advocate of indexing. He compares active investing to playing tennis against a top professional such as Novak Djokovic, rather than hitting against a practice wall. Unless you have a genuine edge, and most investors don't, the sensible move is to step off the court and simply take the average market return. As he memorably puts it, mediocre is beautiful when the alternative is below-average returns.

The takeaway: work out what you truly want from investing, as distinct from what you need. If it's excitement or prestige you're after, you should probably look elsewhere, and let a low-cost index approach quietly do the heavy lifting.

Chapters / Key points

• What index or passive investing actually is
• Why for every above-average investor there's a below-average one
• Meir Statman and the ideas behind "Finance for Normal People"
• Why investors are more rational than commonly assumed
• Telling the difference between a "want" and an "error"
• The hedge fund example: paying for status versus returns
• Why active investing is like playing tennis against Djokovic
• Why taking the average market return is the smart choice
• Working out what you want versus what you need from investing

Transcript

What is index or passive investing?

RP: Meir Statman is one of the world's best-known experts on behavioural finance. A Professor of Finance at Santa Clara University, he's written a book called "Finance for Normal People." His central argument is that there's been too much focus in the past on the irrational nature of investor behaviour. Most people, he says, are far more rational when it comes to investing than is commonly thought, and have perfectly normal wants and needs.

MS: We want things that are very simple. We want to be rich. We don't want to be poor. We want to take care of our kids. We want to acquire high status. Some of us want to be true to their values. We want to play games in the market, for example. And once you look at what people want, you can distinguish what is a "want" and what is an "error." And then you can help people do better satisfying their wants without falling into the pitfalls of errors.

RP: So, what can ordinary investors learn from Meir Statman's book? How can they avoid making potentially costly mistakes?

MS: Well, the lessons are: figure out what it is that you want. So, for example, is status important to you? And is your way of getting status by buying alternative investments, like hedge funds? OK. Hedge funds are lovely because they are available only to the rich. And so you can just say, "I'm into hedge funds," and we know that you're rich without you bragging about it, which is really very, very nice. But the returns of hedge funds to investors, not to their managers, are lousy, so ask yourself, "Is it worth it for me to pay these kinds of fees for feeling that I'm a member of a special club?" You know, alternatively, you can fly first class. You can donate money to charity. There are many ways to increase your status. Figure out what is a good way, an economical way, for you to do that.

RP: Meir Statman is a big fan of indexing. Active investing, he says, is a game you'll probably lose, so the vast majority of investors should simply take the market return instead.

MS: In the stock market, the stock market is like playing tennis against possibly Djokovic on the other side. This is not like playing tennis against a training wall. And so you always have to ask yourself, "What is the advantage that I have over Djokovic? Do I have an extra-size racquet? What do I have?" And for most people the answer is nothing. And so, why play that game when you can just sit yourself on the sideline and get the average return? Remember, for everyone who gets an above-average return there is going to be someone with below-average returns, so mediocre is beautiful relative to getting below-average returns.

RP: So, work out what it is you want from investing, as opposed to what you need. And if it's excitement or prestige you're looking for, you should probably look elsewhere.