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Amai risee.The Power of Passive InvestingBy Allan Roth I Jan 31, 2011 I 1 Comment

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Do you feel lucky? Well, after reading Rick Ferri's new book, The Power ofPassive Investing, let's hope you are if you're planning to bet against the power ofpassive investing. Here are some key points from Rick's great new book, with aforward written by none other than Vanguard founder, Jack Bogle.

The illogic of the active vs. passive debate

Though many active investors claim this debate will never be settled, they point tomarket anomalies as evidence the efficient market hypothesis (EMH) is flawed.Ferri is one of the few who refuses to take the bait and notes what Nobel Laureate,William Sharpe, wrote about years ago. Active investing as a whole mustunderperform passive. And the reason it must is because passive earns the market return less a lowexpense, while active earns the market return less a much higher expense. It's simple arithmetic thatsettles the debate, making the EMH about as relevant to the argument as the price of tea in China.

The odds of a single fund beating the index aren't so bad

Beating the broad low cost index fund has proven to be a difficult task. In fact, it's much more difficultthan beating the Wall Street Illusions of besting the S&P 500 index, stripped of dividends. Ferricondenses the wealth of academic research to show that roughly 42 percent of active funds beat theirbenchmark index fund over any given year. The odds drop to about 23% over a ten year period.

The odds of a portfolio beating an index are dismal

In his book, Ferri points out that few investors own only one fund. He quotes some academic research,including a study from yours truly, that frame the odds of multiple funds beating index funds over aperiod of years. The odds of a 10 fund active portfolio beating the index over a 25 year period drop toless than one percent or, in other words, has a 99 percent chance of failure.

Your odds are low but so is your payoff

Taking into consideration that active investing has low odds, then the only rational argument to utilizethis strategy would be that it must have a high payout. And if you happen to be in that lucky onepercent, it's a done deal that you'll get rich, right? Actually, not so much. Ferri looked at the payout ofboth the winning and losing active funds and found a very different outcome. The average payout fromthose winning funds is not nearly enough to compensate for the losses of the losing funds. Or, to put itanother way, active investing takes on more risk for a lower expected return.

5 Steps to building a passive portfolio

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The Power of Passive Investing - CBS MoneyWatch.com Page 2 of3

Ferri goes far beyond showing the odds and the payouts of active investing. He actually walks thereader through the process of constructing a great passive portfolio.

1. Determine the portfolio's objective.

2. Analyze various asset classes.

3. Create a strategic asset allocation.

4. Choose the low cost securities.

5. Implement and rebalance.

My conclusion

One of my favorite quotes ever is from Matthew Emmert, of the Motley Fool:

"The best thing you can do as an investor or a gambler, is to know the odds of the game you're playing-because not knowing them will cost you."

If investors truly knew the odds and the payout from active investing, few would take their nest eggsand try to defy those odds. Ferri makes such a compelling case for passive investing, that it should berequired reading for every trustee of pension funds and endowments.

If you are a passive investor, this book will validate your investing path and confirm your brilliance. Ifyou are on the fence, it will tip you over to higher returns with less risk. If you are employed by WallStreet, you'll hate it with a passion.

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The Power of Passive Investing - CBS MoneyWatch.com Page 3 of3

Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investmentadvisory firm that advises clients with portfolios ranging from $10,000 to $50 million. He is mocked ona semi-regular basis by some financial professionals for his hourly fee model and its obvious inability tomake him rich.

Roth is also the author of How A Second Grader Beats Wall Street. He teaches behavioral finance atthe University of Denver and is an adjunct faculty member at Colorado College.

Allan Roth

Allan Roth has a lot of credentials (CFP, CPA, MBA) and business experience (McKinsey consulting andofficers of mega-billion dollar companies). But he insists that said credentials and business experiencedo not interfere with his ability to keep investing simple.

Roth has worked with many a lawyer over the years, so he feels compelled to note that his columns arenot meant as specific investment advice, especially since any such advice would need to take intoaccount such things as each reader's willingness and need to take risk, which can vary significantly. Hiscolumns will specifically avoid such foolishness as predicting the next "hot stock" or what the stockmarket will do next month. Roth's goal is never to be confused with Jim Cramer .

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