Active vs. Passive Investing
The conventional wisdom says you can’t beat the market. That’s mostly true, but not entirely.
The Conventional View
>90% of active fund managers underperform index funds over 15+ years (S&P Dow Jones Indices, 2024). Professional fund managers with teams, data, and resources still lose to simple index funds. The SPIVA Scorecard is consistent across countries and time periods.
This is why passive investing became gospel. And for most people, most of the time, it’s the right answer.
The Exception: Warren Buffett’s Approach
But here’s the nuance: some investors do beat the market consistently. Warren Buffett, Charlie Munger, and a handful of value investors have demonstrated that patient, disciplined investing in high-quality businesses at fair prices works.
The key differences:
- They wait for extreme valuations. They don’t try to time every wiggle. They wait for fat pitches.
- They buy compounding machines. Businesses with durable competitive advantages that can reinvest capital at high rates.
- They hold for decades. Not months or quarters.
The Bimodal Approach
The best strategy isn’t pure passive or pure active. It’s bimodal:
Layer 1: Index Fund Base (80-90%)
Low-cost index funds as your always-on default. This runs automatically through Automated Investing. No decisions required. Captures market returns with minimal fees.
Layer 2: Opportunistic Value (10-20%)
A smaller allocation to high-quality compounding businesses, purchased only when they’re cheap. This requires:
- Identifying businesses with durable competitive advantages
- Waiting for significant undervaluation (margin of safety)
- Having the patience to hold for 10+ years
When To Buy Individual Stocks
Only when all of these are true:
- You understand the business deeply
- The company has a durable competitive advantage
- The price offers a significant margin of safety
- You’re prepared to hold for a decade or longer
- You won’t panic sell in a downturn
If any of these aren’t true: stick to index funds.
The Math Still Favors Simplicity
| Approach | 30-year return on $10k/year (7% market) |
|---|---|
| Index fund (0.03% fee) | ~$944,000 |
| Active fund (1% fee) | ~$761,000 |
| Active trading (tax drag + fees) | Often worse |
For most people, the index fund approach is optimal. The bimodal approach is for those willing to put in the work to identify exceptional opportunities.
Definition
The active vs. passive investing debate asks whether investors should try to beat the market through stock selection and timing (active) or simply own the entire market through low-cost index funds (passive). The evidence overwhelmingly favors passive: >90% of active fund managers underperform index funds over 15+ years. However, a small minority of disciplined value investors (Buffett-style) have demonstrated that patient, long-term investing in high-quality businesses at fair prices can work. The optimal approach for most people is bimodal: 80-90% passive index funds as a base, with an optional 10-20% allocation to individual high-conviction positions — but only if you meet strict criteria for understanding, valuation, and holding period.
When This Applies
- Starting to invest: Default to 100% passive (index funds). Active allocation is optional and advanced
- Tempted to pick stocks or time the market: Remember that 90%+ of professionals fail at this. You’re unlikely to be the exception
- Evaluating an active fund or advisor: Compare net-of-fees performance to a simple index fund over 10+ years
- Considering an individual stock purchase: Apply all 5 criteria (understand the business, durable advantage, margin of safety, decade+ hold, no panic selling). If any fail, stick to index funds
- Reviewing portfolio fees: A 1% annual fee on active management can cost ~$180k over 30 years on a $10k/year investment
Related
- Protocol: Automate Investing (implement the passive base automatically)
- Concept: Asset Allocation (the decision that actually drives 91% of returns)
- Concept: Compound Interest (fees compound against you; returns compound for you)
- Anti-Patterns: Wealth Anti-Patterns (stock picking, day trading, market timing)
The goal isn’t to beat the market every year. It’s to own great businesses at reasonable prices and let compounding do the work.
See Automated Investing for the core protocol.