Can Passive Investing Be Detrimental To Young Investors?

Passive investing aided by the rise of Exchange-Traded Funds (ETFs) has certainly been a net benefit to the investment landscape. However, is there a case where it can do more harm than help?

Let me first clear the air. We love ETFs at 5i Research and Canadian MoneySaver and think they have been a fantastic innovation for all investors, particularly Do-it-Yourself (DIY) investors. They offer a simple and easy way to gain broad and instant diversification at a low cost. They have also driven fees lower on other products across the investment landscape which is hard to argue as a negative. What we are discussing below, however, has less to do with the value that ETFs offer and more to do with the trend you often see that encourages young investors to just “go passive”. The refrain goes something like this:

“You can’t beat the market, so don’t bother and just buy diversified ETFs.”

For many investors, this type of advice is certainly sound, but encouraging young investors starting out to do this might actually prove more dangerous over the long-term.

Here’s why:

Make mistakes when you are young with less money to lose.

If you are going to make a mistake, in almost all cases it is probably better to make them young. With investing, you have more time to bounce back from a mistake but perhaps more importantly, the dollar value with which a mistake is being made is going to be far lower. A mistake at a young age is going to be far less impactful than at a later age and be assured, mistakes will be made whether you are active or passively investing.

As a 20-something that retires 40 years later (hopefully), you are probably not going to look back at that initial $10,000 you (maybe) lost in the market and view that as the big difference-maker in your retirement. However, if that experience turned out well and led to added financial security, you will probably view it as one of the most important financial decisions you ever made.

A few wins early on can make a big difference down the road.

We can argue all day about the likelihood of an investor finding a big winner and then even holding onto it, but it does not mean it cannot happen and it is not worth pursuing. Being able to invest in a Shopify or a Constellation Software at an early age, even with a small dollar value, can become a financially life-changing event. I am not talking about a stock win so big that you can “retire”. I am talking about a healthy return that helps you then put a down payment on a house. Or a larger nest egg that gives you a bit of breathing room on your savings rate. It doesn’t have to be a home run but one or two big winners in a portfolio can make a big difference for a young investor trying to build a sound financial footing.

Perhaps overlooked here is the compounding power. If an investor has some good wins early on, those funds can then be reinvested in something safer that can then compound for a much longer time. So, there are certainly compounding impacts over the long-term that these early wins can provide. As noted, if those investments end up being duds, making that mistake at a young age preferable than at a later age.

3. You have more time at a young age.

Self-explanatory here but for better or worse, investing in stocks does take time in some form or fashion. Being younger with less obligations is the best time to research investment and finance principles if interested. Not to mention, it almost certainly will pay dividends in other areas of your financial matters. So, starting investing young is when an individual has the best probability of success because it is when they have the most time to do it but also have the most time to let those financial decisions and learnings to generate returns (time in the market).

Additional dividends here are in areas of career search or understanding how businesses work. Knowing what companies do and how they make money helps an individual think about companies and industries they may want to work in and also the tactics companies use to get you to buy their products!

4. You will get the “itch” to invest someday…

So, best to do it when the risks of a mistake are far lower. This relates to the initial point on making mistakes early, but more to my belief that most people who are already passively investing will, at some point, get an itch to invest in stocks on their own. Put simply, when is it a better time to venture into investing in stocks: At a young age with a $10,000 portfolio OR later in life with a $300,000 or larger portfolio? I think most would agree the earlier, and less capital at risk, the better. Let an investor scratch the itch and learn any lessons early instead of delaying the inevitable when the costs could be higher.

5. The career advice metaphor:

Think back to when you finished your education to head into the real world. Or maybe when your kids had finished school and were seeking career advice. Conventionally, what would most people tell younger individuals or their younger selves when seeking a career?

I can’t speak for everyone, but I think most would give the average individual the following guidance: “When you are young is the time to take risks and make mistakes. The older you get, for better or worse, the more difficult it becomes to take those risks.”

However, this is the opposite we often tell investors starting out. We often encourage them to go passive and to not take risks, when this is precisely the time to take risks if you are going to at all. What’s more, taking risks in the stock market is still probably less risky than career moves like starting your own business. So why do we encourage one but not the other?

There are two major beliefs I have when it comes to investing. The first is that everyone who is able should begin investing as soon as they can. I don’t care if it is passive, active, DIY or with an advisor. The other belief is that while it might not be easy, investing in individual stocks can be one of the best ways to bring financial independence within reach. Most readers probably agree with the first point while some might argue the second and that is both reasonable and fine. But discouraging others at a young age from taking these types of steps that might help them reach financial independence just feels like the wrong approach and could very well lead to higher costs down the road in the form of lost opportunities, mistakes with larger sums of money or both.

Ryan Modesto, CFA, is CEO at 5i Research Inc. in Kitchener, Ontario. He can be reached at ryanmodesto@5iresearch.ca.