Newsletter #6: Passive Isn’t Always Lower Risk

Key Insight:

The idea that passive investing is automatically safer than active management is seductive—but flawed. Index funds might be 'passive' in execution, but they are far from passive in risk.

Index Funds Have Structural Biases

Passive strategies typically track market-cap-weighted indexes, like the S&P 500. That means more money is allocated to companies simply because they are bigger, not better. In 2024, just 7 stocks made up over 30% of the S&P 500's weight.

This concentration can expose investors to hidden risks. For example, when tech stocks surged in the late 1990s, the Nasdaq-100 became extremely top-heavy—then lost nearly 80% of its value in the 2000 crash.

Passive Fuels Bubbles

When trillions of dollars flow into passive funds, they are blindly buying the winners of yesterday. This feedback loop amplifies bubbles. No one is analyzing whether the prices make sense—they're buying because the system says so.

No Quality Filter

Passive funds don’t discriminate. You own every company in the index regardless of financial strength, valuation, or management quality. That can work in bull markets but leaves you vulnerable when fundamentals matter again.

Rethinking 'Risk'

Many investors equate volatility with risk, but real risk is permanent capital loss. A fund that avoids big drawdowns—even if more volatile—might actually protect wealth better than an index fund loaded with the next Enron or Lehman Brothers.