Book Review: The Power of Passive Investing by Rick Ferri

Rick Ferri is the founder of a Michigan investment advisory firm Portfolio Solutions. I came to know Rick from his postings on the Bogleheads Investment Forum. When the PR person for the publisher contacted me about Rick’s new book The Power of Passive Investing, I eagerly asked for a review copy.

Passive investing means investing in index funds and ETFs, not in mutual funds with a manager trying to beat the market, by picking and screening (“security selection”) and/or by going in or out of market at opportune times (“market timing”).

Passive investing isn’t new. Princeton professor Burton Malkiel has been talking about passive investing for nearly 40 years in his classic book A Random Walk Down Wall Street. Vanguard founder John Bogle has been talking about passive investing in his many speeches and books including Common Sense on Mutual Funds and The Little Book of Common Sense Investing. Long time readers know I’m already convinced by Malkiel and Bogle that passive investing is the way to go. So what’s new in this book by Rick Ferri?

First of all, just because something is already publicized doesn’t mean we shouldn’t talk about it any more. Calculus hasn’t changed much in the last 100 years. Textbooks on calculus are still being published. Each book add its own flavor and angle to teaching basically the same thing.

The Power of Passive Investing focuses on passive investing versus active management like a laser beam. It doesn’t talk about how much you should invest, how you should do your asset allocation, or if you should invest in a 401k plan or Roth IRA. It’s strictly on why you should invest in index funds and ETFs and not bother with picking actively managed funds hoping to beat the market.

With that narrow focus, it does a good job. It draws upon numerous academic studies both on US and international markets to show that actively managed funds fail to deliver the results investors hope for.

The books shows that in any one year, you have about a 1-in-3 chance of selecting an actively managed fund that beats an index fund in the same category. When you think about it, 1-in-3 isn’t too bad. If you exclude some funds that don’t have much hope to begin with — load funds and funds with very high expenses — your odds are probably better than 1-in-3. However, as time goes by, the odds become smaller and smaller. Over the long term, it will be very difficult for an actively management fund to beat an index fund.

In addition, even when you chance upon an actively managed fund that beats the index fund, the added return isn’t much, compared to the amount of underperformance when you aren’t so lucky.

I also learned from the book the concept of an “active portfolio” versus an active fund. It’s difficult enough to pick a fund that beats an index fund over the long term. It’s exponentially more difficult to have a portfolio made up of multiple actively managed funds to beat a portfolio of multiple index funds. You may have a winner in the active portfolio but the other losers will drag it down and make the active portfolio underperform the index portfolio. That was my Ah-Hah! moment when I read the book.

The book didn’t mention it but I would also like to add there’s a behavioral benefit to passive investing. When you invest passively, there are fewer decisions to make and you are likely to make fewer mistakes.

All investment managers will have a bad year. When that happens, you have to worry if the investment manager is a bad manager; was a good manager but has lost the touch; or will be proven right eventually if you just stick it through. If you are likely to jump from one fund to another when your fund does poorly, you have one more reason to invest passively.

Rick Ferri started a website and a blog not too long ago at RickFerri.com. His blog is worth subscribing to.

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