- Active investing involves constantly buying and selling securities to profit from short-term changes in the stock market. This strategy is often very beneficial when the market is doing particularly well.
- Passive investing is the opposite of active investing: it employs a buy-and-hold strategy to profit from long-term trends in the stock market and is used by investors who want to avoid risks.
- Both active and passive investors may exhibit the ostrich effect, or a tendency to ignore bad news in the market.
There is a close relationship between passive investing and the ostrich effect, which we will explore here.
What Is Passive Investing?
Passive investing is a long-term strategy that involves restricted buying and selling of securities. A passive investor buys securities to hold long term, because he or she believes that stocks will rise in the long run.
An individual who invests passively does not seek to beat the market; he or she just wants to match the market's returns. To accomplish this, passive investors often invest in index funds and exchange traded funds (ETFs) that mirror market indices. This is why passive investing is sometimes referred to as index investing.
Advantages of Passive Investing
Some advantages of passive investing include the following:
- Lower costs and higher profits: Investing in index funds usually incurs lower management fees, because a passively traded portfolio requires fewer resources and less time to manage than an actively traded portfolio. If an actively traded portfolio yields the same returns as a passively traded portfolio, the passive investor will receive a higher return, because when investors sell a security, the amount of profit they receive is equal to the sell price less the buy price, minus management fees and trading commissions.
- Automatic gains from market upswings: Since passive portfolios are constructed to closely follow the performance of market benchmarks like the S&P 500, the passive investor experiences gains when the market is in an upswing.
- Fewer bad management decisions: An actively traded portfolio relies on management to decide which securities to trade and when to do so, whereas a passively managed portfolio is designed to automatically track all the securities traded on a particular index. Thus, a passively managed portfolio reduces the risk that the investment will be affected by bad management decisions.
Disadvantages of Passive Investing
Some disadvantages of passive investing include the following:
- Automatic losses from market downswings: Since passive portfolios mirror the market, when the market experiences a downturn, the passive portfolio suffers, and the investor might experience losses if he or she chooses to sell during this time.
- Inability to beat market: A passive investor cannot outperform the market. If an investor believes that he or she can beat the market, then passive investing is not the right strategy.
What Is the Ostrich Effect?
The ostrich effect is a term used in behavioral finance to describe the habit of some investors to pretend that bad news in the market doesn't exist. This behavior is named after the bird because investors who behave this way "bury their heads in the sand," or ignore bad news in the market. This behavior is often displayed by investors who are risk averse.
Advantages of the Ostrich Effect
The advantages of the ostrich effect can be both emotional and financial.
- Emotional benefit: The psychological impact of bad news is limited or almost nonexistent.
- Advantages from market cycles: The market operates on a cyclical basis: it goes up and down frequently, and the only uncertainty is the duration of each phase. If investors sell their securities whenever they hear bad news, they could sustain unnecessary losses as well as miss out on great returns when the news turns good. Investors who ignore bad news are still in the market when returns improve, putting them in the right place at the right time.
Disadvantages of the Ostrich Effect
The ostrich effect has two disadvantages:
- Ignorance leads to major losses: If market bad news is a warning that a particular investment is unlikely to rebound, ignoring the situation can lead to major losses for the investor.
- Increased potential for missing good investment opportunities: Burying your head in the sand when it comes to bad news in the marketplace means that if a great investment opportunity arises or results from the bad news, that chance is lost.
Passive Investing Versus the Ostrich Effect
It is important to know the relationship between passive investing and the ostrich effect, so that you are aware of the investment behavior you are engaged in and the effect it can have on your assets.
Passive investing and the ostrich effect are similar in that investors engage in both because they are risk-averse and want to avoid losing money. However, a passive investor does not ignore news about the market, good or bad. A passive investor is willing to trade potentially higher returns for the relative safety of going along with the market.
On the other hand, an investor who exhibits the ostrich effect ignores bad news about the market and pretends it does not exist. The ostrich effect is not limited to just one investing style - an active investor can also behave like an ostrich when there is bad news about the market.
Regardless of the investment strategy you choose to adopt, being knowledgeable about events in the market, both good and bad, can mean the difference between a gain and a loss. Choosing to invest in market securities and then deciding not to pay attention to the market on a bad day is a surefire way to lose money.
The Bottom Line
As an investor, it is very important that you be aware of news from the market and how it might affect your investments. Ignoring any news, especially bad news, can lead to poor investment decision-making and major losses.