There are two primary ways in which people invest in the market. A passive investor takes a buy-and-hold approach, while an active investor will try to sell in times where the market is thought to be at a peak and buy again when the market is thought to be in a trough.

At first glance, an active approach appears to be far superior to a passive one. If you sell at the peak, wait for the market to drop and then reinvest, your returns would be much greater than if you simply held your original investment. The problem with this approach is that no one has the ability to predict the future.

Unfortunately, this inability to reliably predict the future is routinely obscured by news stories of people who have had tremendous sudden success when actively trading in the market. These stories are fueled by the media’s need to sell copies and our own natural tendency for greed. News reports about passive investing and the academic research supporting it is not usually front page material.

 

When attempting to beat the market, there is a great risk of selling before a run-up and/or buying before a dip. Additional trading costs are also incurred regardless of the gain or loss of the investment. In non-qualified accounts, short-term capital gains are further diminished by the individual’s ordinary income tax rate, as opposed to the significantly lower long-term tax rate of 15%.

Passive investing inherently will have fewer dollars lost to transaction costs, management fees, and taxes. The difficulty for active management to overcome these factors has been compared to consistently hitting a moving bullseye when blindfolded!