Passive Investing
Passive Investing

Passive Investing

Passive investing over relatively long time-periods is a strategy followed by many individuals. In this paper, empirical evidence is presented beginning January 1950 that demonstrates that the success of this strategy is dependent not only on the length of the investment horizon, but also by the date of the initial investment. 10, 20, and 30-year periods are examined for both a lump sum initial investment and then for a monthly annuity investment. (Page 1)

Investors are advised to commit capital to the markets as early as possible to capture the power of compounding. On the surface, this seems to be prudent advice as money will not increase in value while in an individual’s pocket. However, we also know that the U.S. stock market can entail a great amount of risk for an individual. (Page 2)

Investors will invest passively in a well-diversified manner by placing their wealth in a Standard and Poor’s (S&P) 500 index. Warren Buffett has advocated this type of investment. In his Berkshire Hathaway shareholder letter dated February 28, 2014 he states in regard to a trust for his wife “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (Page 2)

Given constant inflows, this will result in more wealth being invested toward the end of the investment period than at the start. It will also be empirically shown that the date of the initial periodic investment results in a significant difference in the investor’s final payoff. (Page 2)

Elton, Gruber, and de Souza (2019) state that assets under passive management has increased from 16.4% to 26% over the last five years. (Page 3)

Banerjee and Hung (2013) compare returns for actively managed funds using momentum trading strategies to return of equally weighted passively managed funds. (Page 3)

In this discussion, the real value will be placed in parentheses behind the nominal dollar quantity. For example, if the initial investment is made on January 1, 1950, the investor will have $5,896.36 ($4,744.18) in their account at the end of 10 years. If the $1,000 was invested instead on October 1, 1964, the ending value in the account would only have been $1,050.28 ($639.80). An individual fortunate enough to make their initial $1,000 investment on September 1, 1990 would have ended up with $6,046.18 ($4,613.54) at the end of 10 years, but an unfortunate individual that initiated their investment on March 1, 1999 would only end up with $727.63 ($562.85). (Page 4)

Over a large number of 10-year investment periods, Exhibit 1 (appendix) shows that during most time periods, a passive investment scheme using an S&P 500 index would be superior to just retaining the $1,000 in cash. (Page 4)

Exhibit 2 (appendix) expands the investment horizon from 10 years to 20 years. As before, nominal dollar quantities will be reported with real values in parentheses. In examining the potential ending values, it is clear that the most fortunate time to have invested the initial $1,000 would have been on April 1, 1980. The ending value in the investors account would have grown to $29,181.65 ($13,680.25). The least amount a 20-year investor would receive is $3,058.40 ($1,106.94) and this occurred if they made the initial $1,000 investment on January 1, 1999. (Page 4)

Exhibit 3 (appendix) examines the impact of a 30-year investment horizon on the ending value of a one-time lump sum investment of $1,000. The value of longer investment horizons becomes obvious as the investment horizon has increased from 10 years to 20 years and finally to 30 years. An individual that invested their $1,000 on July 1, 1970 would end their 30-year period with $59,621.59 ($13,349.44). The unfortunate individual who invested on October 1, 1955 only ended up with $13,693.31 ($3,374.72). Even in the worst-case scenario, the investor more than triples their real spending power. This can be compared to the 20 and 10-year horizons where the real spending power remained nearly constant and decreased, respectively. (Page 5)

As the minimum values indicate, a 10-year investor can end up with less than their initial value on a nominal basis ($727.63) with decreased purchasing power as demonstrated by the real value ($562.85). (Page 5)

By investing for longer time-periods, investors are able to guard themselves against the volatility of the shorter 10-year period (Page 5)

To replicate this investing cycle, an investor will be assumed to place $50 into a passive S&P500 index at the start of each month over 10, 20 and 30 years investing periods. This pattern will result in greater quantities of wealth being invested as individual ages. This investing style implicitly places importance on dollar weighting (Page 6)

Similar to a one-time investment at the start of the period, a 10-year investment horizon does not ensure the investor of ending with more nominal wealth. (Page 8)

The results detailed in this paper indicate that the investment horizon length (persistence) as well as the timing of each investment (luck) impacts an investor’s ending wealth. When considering a one-time investment, the ability and willingness to invest for longer periods is demonstrated to be beneficial. An individual that commits for 20 or 30 years over the time of this paper’s sample is assured of a positive outcome though there is still a substantial difference on ending value based on the initial investment date. (Page 8)

Still using a passive S&P500 index investment strategy, an individual that consistently makes additional contributions into their portfolio also realize more dependable positive results over longer investment horizons. Only individuals making monthly contributions over the 30-year horizon have positive returns on both a nominal and real basis over the sample period. Individuals that invest for 20 years realize positive nominal returns, but have periods with negative real returns. The shortest horizon investor examined (10 years) is shown to potential have negative returns on both a nominal and real basis. (Page 8)

An investor needs both luck and patience. The results indicate that longer investment horizons are beneficial, but that factors such as recessions for which an investor cannot account will have a critical impact on portfolio value even when investing through a relatively safe, passive method as is often advocated. (Page 8)