Why Passive Investing Gets Better in Retirement

Index funds are easier for retirees to use and cost less than actively managed funds.

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passive investing index funds retirement savings portfolio
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By David Ning

Many people wonder whether they should choose passive or active funds for their portfolio. To me, passive investing is the only sensible way to invest. The data strongly points to higher risk-adjusted returns for passive portfolios. Passive portfolios also have a variety of other advantages that will become even more pronounced once my retirement years roll around, which is precisely the time when I need my money to work for me the most. Here are a few reasons passive investing works incredibly well in retirement:

Passive portfolios take less time to manage, so there's more time to have fun. You may be motivated enough to pore through pages and pages of information about active mutual funds to find those able to outperform the market, but do you really want to do that over and over again in retirement? And that's assuming you are lucky enough to have the knowledge and skill to find the gems in the first place. How much time do you plan to devote to the act of investing? Passive portfolios take almost no time to manage. Set them up, rebalance back to the predetermined asset allocation periodically and you are pretty much done. With the extra time on your hands, you can spend more time having fun.

There are fewer ways to make mistakes. The beauty of a basket of index funds that's held through thick or thin is that you don't need to constantly make investment decisions that could make or break your portfolio performance. Even a mathematical wonder who seldom makes mistakes could experience cognitive decline as he advances in years.

The emotional toll of investing in equities is less taxing. Market valuations decline all the time, and it can be just as gut wrenching to see a passive portfolio balance shrink as an active one. The difference, however, is a passive portfolio's valuation is more likely to come back up. This is because passive investing is based on the total market. By hanging on and not selling, you are indirectly making a bet that the U.S. and global economies are going to continue to grow through time –- an extremely likely event unless the world is ending. Active investing, on the other hand, is a bet that a select few investments you own are going to continue to grow through time. Sometimes this works out, but as people who owned tech stocks during the dot-com bubble learned, sometimes you can lose a lot.

Active portfolios complicate your taxes. Another seldom talked about gotcha with active portfolios is the increase in tax liability. Let's assume you outperform the index even after accounting for taxes. It still means you have to spend more time filling out extra tax forms. I used to day trade, and tax time was a nightmare. First, I needed to record and verify thousands of transactions and make sure everything is accurate. Then, I have to pass them onto my CPA who then charges me to put them onto the appropriate tax forms, only for me to double check them again. And that's not all. Some investments distribute K1s, and they would always send them after the original tax deadline. Sure, you can always file an extension, but it's a hassle. And if you use a certified public accountant, that also means more costs because they can charge you billable hours. Does this sound like a stress-free retirement to you?

Passing a portfolio on to your heirs is a simpler process. You may love spending hours a day investing and be able to trounce index fund returns, but will your spouse be able to do the same if necessary? With the added complexity of an actively managed portfolio, will your heirs be able to prudently buy and sell all the investments you've spent decades tweaking? How do you expect anybody to inherit your fortunes and still manage to live the lifestyle that you hope for them? This won't be trivial for passive portfolios either, but at least a plan is possible because the theory and decision points can be articulated and written down well in advance. You want your heirs to be able to continue growing what you started.

There will always be people arguing the return prospects of an active versus passive portfolio because you can always find someone doing better using either method. But no matter which side you are on, there should be no question that a passive portfolio is much simpler. During retirement, would you rather spend your time relaxing, or poring through prospectuses and financial reports? The decision is up to you.

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