Nothing can demonstrate the advantages of a passive approach to investing better than a natural disaster. Active management is based on the premise that the fund manager can beat the market. They claim to be able to do this by leveraging their superior skills to make predictions about stock selection and market timing.

However, an active manager could not have foreseen the recent events in Japan. The holdings in their funds would have performed as well as the same stocks in a tracker fund. By the time the news of the disaster is out it is already too late for the manager to make a profitable move.

We believe that markets are efficient, namely that the price of a stock reflects all known (and expected) information about that stock. When unexpected news (bad or otherwise) breaks – prices are adjusted to reflect this new information almost instantaneously. Much too quickly in fact, for any single investor to take advantage of any short term price anomalies. Even in this global, connected economy it is impossible. So does the active manager hold or fold when news of the disaster spreads on Twitter, YouTube, Facebook, etc?

Does the manager sell to prevent any further losses or sit tight to wait for the bounce? Remember that the active manager is charged with beating the market but whether this occurs or not the investor pays the annual charges.

An index tracking fund has no such problems. Yes the fund value falls as the value of the fund’s holdings drop – just as is the case with the active fund. However the difference is that the annual charge of a index fund is significantly lower – there’s no need to pay a manager hefty annual management charge for stock selection or market timing calls. Instead just own everything in the index. The investor can then adopt a “buy and hold” strategy.

It may seem counter intuitive to “sit tight” when the market is falling. After all if you know the market is going to drop why sit there and take it? The answer is simple. If you’re not in the market you won’t benefit from any rebound. The alternative is to time the market – and that’s really tough.  To time the market correctly the manager has got to get it right twice: selling near the top of the market and buying back in near the bottom  i.e. when prices have started (or are just about to start) increasing.

A passive fund doesn’t need to time the markets. Just remain invested at all times. If investors have adopted a long term “buy and hold” strategy then short term fluctuations become background noise. Remember it is “time in” the markets not “timing” the markets that really matters.