Especially during periods when the market is on the rise, many investors experience regret, wondering whether they could have earned better returns than they did had they selected a different investment approach. Unfortunately, most investors who succumb to this type of regret are using the wrong tools and put themselves at a significant disadvantage. They invest in what are known as “actively managed” funds or other active vehicles, whose managers seek to outperform the market by predicting the future of either individual stocks or sectors, or entire markets.

Passive Investing in Efficient Markets — Active investors assume that the market is generally “inefficient.” If the market were inefficient, it would mean that clever individuals (or their clever brokers) could regularly exploit opportunities when holdings were trading for more or less than they were actually worth. Opportunities would need to be of sufficient frequency and value to cover the costs of consistently seeking and executing such trades.

There is significant academic evidence that the collective wisdom of all market players — especially in today’s electronic era — results in highly efficient markets that reflect fair pricing almost instantaneously upon release of any news (good or bad) that might affect a holding’s price. For example, a 2002 Journal of Financial Economics study analyzed how stock prices reacted to good and bad news reported on CNBC’s Midday Call. Following a stock’s positive coverage, its price increased within seconds, with the phenomenon lasting approximately a minute. Bad news reaction was more gradual, lasting for 15 minutes following the news. The study’s authors concluded that, “the market is efficient enough that a trader cannot generate profits based on widely disseminated news unless he acts almost immediately.

A passive investor assumes that opportunities to exploit inefficiencies are too few and far between to effectively pursue. It would be like spending one’s day trying to find lost dollar bills on the sidewalk. It’s fun if you have such luck, but it’s no way to earn a living. That is why we acknowledge that the markets are generally efficient and we advise according to a passive rather than an active investment approach.

Passive Investing To Control Costs — Passive investing also provides a highly effective way to address another factor that is critical to your investment success: controlling costs.

All mutual funds and separately managed accounts have expenses that include management fees, administration charges and custody fees. These are expressed as a percentage of assets. The average annual expense ratio for all retail equity mutual funds handily exceeds 1 percent. In comparison, the same ratio for passive asset class funds is typically only about a third of all retail equity mutual funds. All else being equal, we would expect lower costs lead to higher rates of return.

Beyond account management expenses, there are many other costs to be managed, including trading/turnover expenses, taxes and “the cost of cash” (incurred when a mutual fund holds a portion of your assets in cash rather than fully invested, continuously earning market returns). Passive investing is not the only way to seek to minimize such expenses, but we have found it to be an effective way.

Passive Investing and Appropriate Asset Allocation — Perhaps the most important determinant of portfolio performance is asset allocation — how your assets are exposed to various risk factors. Because effective asset allocation requires your portfolio to maintain consistent exposure to these risk factors, the investment vehicles from which you build your portfolio also need to stay within their defined target asset classes. Unfortunately, most retail actively managed funds effectively have you relinquish control of your asset allocation. They may overweigh or under weigh specific parts of the market in their quest to achieve higher rates of return, or move a portion of your assets out of the market entirely. In contrast, because of their investment mandates, institutional passive asset class and core equity funds must stay fully invested in the specific asset classes they represent.

Why Our Firm Passively Manages — We conclude with why our firm has adopted a passive asset class approach to investing. We believe our approach fosters a relationship grounded in fiduciary obligation, while effectively incorporating academic evidence on how markets can be used to pursue your financial independence. Just as asset allocation should be among the first steps toward building a long-term portfolio to meet your unique goals, selecting an advisor who espouses a passive management approach can be among the first steps toward building a long-term trusted advisor relationship.