Active vs Passive Investors: The Power of Patience and Discipline

Updated May 3, 2024

Investing has two primary schools of thought: active and passive. Active investors seek to outperform the market by actively selecting individual stocks or other securities that they believe will generate higher returns than the overall market. They may also attempt to time their investments based on market conditions or other factors. In contrast, passive investors aim to match the performance of the market by investing in index funds or exchange-traded funds (ETFs) that track broad market indices, such as the S&P 500.

The debate between active and passive investing has been ongoing for decades, with proponents on both sides arguing the merits of their approach. Active investors believe that by carefully selecting investments and timing their trades, they can generate higher returns than the market as a whole. They point to successful investors like Warren Buffett and Peter Lynch as examples of the potential for active management to outperform.

On the other hand, passive investors argue that the markets are mainly efficient and that attempting to beat the market consistently is a futile endeavour. They cite studies showing that the majority of actively managed funds underperform their benchmarks over the long term, and argue that the lower fees and expenses associated with passive investing can lead to better overall returns for investors.

While there are valid arguments on both sides of this debate, both active and passive investing can be successful strategies if approached with the right mindset and tools. Regardless of which approach an investor chooses, the key to long-term success lies in cultivating two essential virtues: patience and discipline.

Patience is maintaining a long-term perspective and resisting the temptation to make impulsive decisions based on short-term market movements. It means having the fortitude to stick with an investment strategy even during market volatility or underperformance periods. On the other hand, discipline is the ability to adhere to a well-defined investment plan and resist the urge to deviate from it based on emotions or external influences.

Together, patience and discipline form the foundation of a successful investment approach, whether an investor chooses to be active or passive. In the following sections, we will explore the importance of these virtues in more detail and examine how they can be applied to active and passive investing strategies to achieve long-term financial success.

The Importance of Patience

Patience is a critical trait for investors, as the markets can be volatile and unpredictable in the short term. As legendary investor Warren Buffett famously said, “The stock market is a device for transferring money from the impatient to the patient.”

For active investors, patience means waiting for the right entry point and allowing the price to reach the levels dictated by their trading strategy. This can take time, but it’s essential for maximizing returns and minimizing risk. Passive investors also need patience, as they must resist the temptation to tinker with their portfolio during market downturns and trust in the market’s long-term growth potential.

Cultivating patience requires a shift in mindset. Investors need to focus on their long-term goals rather than short-term fluctuations. They also need to be aware of behavioural biases, such as recency bias, which can lead them to make decisions based on the market’s recent performance rather than fundamental analysis.

The Power of Discipline

Discipline is equally essential for investment success. For active investors, discipline means sticking to their trading rules and not letting emotions cloud their judgment. This includes having the discipline to cut losses when a trade goes against them and not chasing after hot stocks or trying to time the market.

Passive investors also need discipline to stick to their investment plan and resist the urge to make changes based on market conditions. They need to have faith in the market’s long-term potential and not panic during downturns.

As hedge fund manager Seth Klarman notes, “The single greatest edge an investor can have is a long-term orientation.” This requires the discipline to stay the course even when the market is volatile or the economy is struggling.

The Role of Mass Psychology

Mass psychology plays a significant role in the markets, as investor sentiment can drive prices up or down regardless of fundamentals. Active investors can take advantage of this by being contrarian and looking for opportunities the crowd overlooks.

For example, during the dot-com bubble of the late 1990s, many investors piled into technology stocks with little regard for valuations. Disciplined investors who avoided the hype and focused on fundamentals were able to sidestep the crash and emerge relatively unscathed.

Similarly, during market downturns, fear can lead investors to sell off stocks indiscriminately, creating opportunities for those with the patience and discipline to buy quality companies at a discount.

As legendary investor Sir John Templeton said, “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”

The Value of Technical Analysis

Technical analysis, which involves studying past market data to identify trends and make predictions, can be valuable for active investors. By using charts and other technical indicators, investors can spot patterns and make informed decisions about when to enter or exit a trade.

However, technical analysis requires great discipline to implement effectively. Investors must have a well-defined trading plan and stick to it, even when their emotions tell them to do otherwise. They also need to be patient and wait for the right setup rather than trying to force trades.

As trader Alexander Elder notes, “The hardest work in trading comes in waiting for the right opportunity. Patience is not a virtue, and it is an absolute necessity.”

Combining Patience and Discipline

Ultimately, the most successful investors can combine patience and discipline in their approach. This means having the patience to wait for the right opportunities and the discipline to stick to a well-thought-out investment plan.

One example is the legendary investor Warren Buffett, known for his patient, disciplined approach to investing. Buffett famously avoids trendy or overvalued stocks and instead focuses on buying quality companies at a fair price. He is also willing to hold onto his investments for the long term, even during market downturns.

Buffett himself said, “The stock market is a no-called-strike game. You don’t have to swing at everything — you can wait for your pitch.”

Active vs Passive: Which Approach Wins?

So which approach is better: active or passive investing? The answer depends on the individual investor’s goals, risk tolerance, and time horizon.

Historically, passive investing has tended to outperform active investing over the long term, as the fees and expenses associated with active management can eat into returns. A 2018 study by S&P Dow Jones Indices found that over 15 years, 92.2% of large-cap funds, 95.4% of mid-cap funds, and 93.2% of small-cap funds underperformed their respective benchmarks.

However, this doesn’t mean that active investing can’t be successful. Skilled active managers who consistently beat the market exist, although they are rare. For investors willing to put in the time and effort to research and analyze individual stocks, active investing can be a viable strategy.

Ultimately, the key to success with either approach is having a well-defined investment plan and the patience and discipline to stick to it. As legendary investor Peter Lynch said, “The key to making money in stocks is not to get scared out of them.”

Conclusion: Active vs Passive Investors

In summary, patience and discipline are essential virtues for investors, whether they choose an active or passive approach. Investors can weather market volatility and achieve their financial goals by cultivating these traits and maintaining a long-term perspective.

Numerous studies and the experiences of successful investors back up the importance of patience and discipline in investing. For example, a study by Dalbar Inc. found that over 20 years ending in 2020, the average investor in U.S. equity mutual funds earned an annual return of just 5.96%, compared to 7.43% for the S&P 500 index. The primary reason for this underperformance was investors’ tendency to buy and sell at the wrong times, often driven by emotions like fear and greed.

Another study by Vanguard found that disciplined investors who stayed the course during the market downturn of 2008-2009 were rewarded with significant gains in the subsequent years. Investors who maintained a balanced portfolio of 50% stocks and 50% bonds saw an average annual return of 7.2% over the following decade, compared to just 0.5% for those who shifted entirely to cash during the downturn.

Successful investors’ experiences also highlight the importance of patience and discipline. Warren Buffett, one of the most renowned investors of all time, famously said that “the stock market is a device for transferring money from the impatient to the patient.” Buffett’s disciplined approach of buying high-quality companies at reasonable prices and holding them long-term has enabled him to generate exceptional returns over his career.

As Benjamin Graham, the father of value investing, noted, “The investor’s chief problem — and even his worst enemy — is likely to be himself.” By mastering their emotions and sticking to a disciplined investment plan, investors can overcome this challenge and succeed in the markets over the long term.

Ultimately, the key to successful investing is not necessarily choosing between an active or passive approach, but instead developing the patience and discipline to stick with a well-thought-out plan through the ups and downs of the market. By doing so, investors can increase their chances of achieving long-term financial goals and building lasting wealth.