A couple of weeks ago, I was trying to explain passive investing to some friends. I could tell from their expressions that my message wasn’t landing, so I decided to switch it up and use an analogy that they understood best: Alcohol. Here’s what I shared.
The cocktail sampler set
Imagine that you love cocktails. You’ve got a favourite cocktail bar close to your office, but what you really want us to try the best cocktails from all around the world.
Now, cocktail lovers will all know about the World’s 50 Best Bars list, which lists the top 50 bars from around the world. Someone came up with a methodology, used it to rank the bars, and collate them into a handy list. For many bars, it’s prestigious to get on that list, but at its core, it’s nothing more than just that: a list.
(I don’t particularly love cocktails, but I know about this list because my wife drags me to a bar on it every time we’re in a new city).
A good way to appreciate the world’s best cocktails is to simply visit as many bars on that list as you can. But that’s going to be expensive: In Singapore, an Old Fashioned can set you back $25-$30. Imagine visiting all the bars on that list and dropping $25 at each one. Add the travel costs, and it quickly becomes infeasible to try ALL the bars on that list.
Now, imagine that there’s a company offering a special “cocktail sampler set”. They’ve visited all the bars on the Top 50 list, bottled a tiny sample from each one, and sell the entire set of 50 samples to you. Every year, when the new Top 50 list is announced, the company simply refreshes their set. They discard the samples from the bars that have dropped out of the Top 50 list, and replace them with the new bars which have entered the list.
How is this similar to passive investing?
Passive investing is like buying the sampler set, but with stocks instead of cocktail bars.
The “World’s 50 Best Bars” is like a stock index, which is simply a list of stocks. For example, the S&P 500 is a list of the top 500 largest stocks in the US: Stocks like Apple, Alphabet, Microsoft, etc. And the Straits Times Index is a list of the 30 largest stocks in Singapore. Anyone can go online and see what stocks are on that list, just like anyone can go online and see which bars are on the 50 Best Bars list.
The company selling cocktail samples is like a fund. There are different types of funds, like mutual funds or Exchange-Traded Funds (ETFs), but don’t worry about their differences for now. At their core, passive investing funds simply offer you an easy way to own a “sample” of all the stocks in an index. They pool everyone’s money, buy all the stocks on your behalf, so that all their investors own a tiny sample of each stock on the list.
Funds which follow the passive investing approach don’t try to predict which stocks to buy. Like the 50 Best Bars example, they simply follow the list. So when a stock drops out of the list, they sell the stock. And when a stock gets added to the list, they buy it.
But why follow this approach?
Why not just put all your money into the #1 stock? Why would you not just visit the #1 bar in the world, and forget about the rest?
Trying to pick the #1 stock, or even the top handful of stocks, is known as “active investing”. A fund which follows an active investing approach is like a company saying “Forget about this stupid 50 Best Bars list. We’ll simply buy cocktails from the bars that we predict will become winners next year.”
But here’s the interesting part: In virtually every part of the world, 9 out of 10 funds underperform the index over the long-run (10 years or more).
Tasting the sampler set beats picking the “best” bars, because “best” this year doesn’t always mean “best” next year. For example, in 2023, Sips from Barcelona took the #1 spot, and they replaced the previous winner Paradiso from Barcelona (what is up with Barcelona and all their top bars!), which dropped from #1 to #4.
It’s never a good idea to go all-in on a single stock (or even a handful of stocks), because you never know what might happen to it. Like bars, stocks can go bankrupt, get into scandals, get whacked by the government, etc. So you always want to diversify into as many stocks as possible.
If you invest in the entire INDEX of stocks (aka the stock MARKET), that tends to go up over the long run. Cocktail bars come and go, but the industry as a whole tends to get better and better.
And that is why passive investing works.
—
For those of you who have been following along, I’m doing David Perrell’s Shiny Dime challenge where I write a response to a writing prompt each week. This week’s prompt was: “Write an article that makes sense of something confusing.”
