This is Part 8. Follow links for Part 1, 2, 3, 4, 5, 6 and 7
For decades investors have been told to begin portfolio construction with a “simple” question:
Should I be a passive investor or an active investor?
The question sounds reasonable but is the wrong question.
In the previous article, Are Total Market Index Funds Passive or Just the Default Benchmarks?, we examined the intellectual foundation behind passive investing and found something surprising. The distinction between passive and active investing depends on accepting a theoretical market portfolio that is unobservable, unknowable, and ultimately replaced by practical proxies such as total-market index funds.
Once that substitution is made, the entire framework becomes circular:
- Define a broad market index as passive.
- Define deviations from that index as active.
- Conclude that investors who deviate are active investors.
But what happens if we reject the premise?
What happens if passive investing is not a natural category at all?
Every Investment Is an Active Choice
Consider an investor who buys a global stock index fund and never changes it.
Conventional wisdom calls this passive.
Yet every step involved an active decision:
- Choosing stocks instead of bonds.
- Choosing public markets instead of private markets.
- Choosing market-cap weighting instead of equal weighting.
- Choosing global diversification instead of domestic concentration.
- Choosing to remain invested during future bear markets.
- Choosing to accept equity risk in exchange for expected returns.
None of these decisions are forced by nature. Each reflects assumptions about the future.
Even holding cash is an active decision. It is a bet that liquidity, optionality, and safety are worth more than the expected return from alternative investments.
The future does not care whether an investor labels their decision passive or active. The future only responds to the exposures they actually hold.
The passive-versus-active distinction creates the illusion that some investors have escaped the burden of judgment. Every investment is a wager on an unknowable future. There are no passive choices – only choices whose assumptions are hidden from view. You place your bets, you take your chances, and you need to know your limitations.
The Problem With Labels
The passive-versus-active distinction is often presented as an objective classification.
In practice it functions more like an identity.
“Passive” has become associated with discipline, humility, evidence, and low costs.
“Active” has become associated with speculation, overconfidence, and unnecessary risk.
Notice what happened.
A descriptive label became a moral label. The discussion shifted from:
What characteristics should a portfolio have?
to:
Which tribe should I belong to?
Once investing becomes tribal, analysis becomes difficult.
Questions about expected returns, valuation, diversification, taxes, liability matching, factor exposure, and behavioral risks become secondary to maintaining membership in the preferred group.
This is one reason the passive vs. active debate has persisted for so long. The labels simplify a complicated world.
They provide an answer before the question is fully understood.
Portfolio Construction
Suppose we remove the labels entirely.
Suppose we stop asking whether a portfolio is passive or active.
What remains?
Portfolio construction.
Nothing more and nothing less.
Instead of asking: “Is this passive or active?”
Ask: “What does this portfolio actually do?”
That shift sounds subtle.
It is not.
Consider the difference.
| Instead of asking… | Ask… |
|---|---|
| Is this passive or active? | What exposures does this portfolio provide? |
| Am I matching the market? | Is this portfolio helping me achieve my goals? |
| Should I own a factor tilt? | Why do I believe this improves outcomes? |
| Are my fees low enough? | Am I receiving value for the costs incurred? |
| Is this diversified? | Diversified relative to what risks? |
The second set of questions is harder.
It requires thinking.
But it also avoids the illusion that some portfolios are exempt from judgment simply because they carry the label “passive.”
The Real Starting Point
Without passive investing as the default answer, portfolio construction must begin somewhere else.
The logical starting point is not a benchmark.
It is the investor.
Every investor faces a unique combination of:
- Spending needs
- Tax circumstances
- Human capital
- Time horizon
- Behavioral constraints
- Risk tolerance
- Legacy goals
- Liability structure
- …
These realities exist whether CAPM is correct or not.
Whether a market portfolio exists or not.
Whether indexing is optimal or not.
A retiree drawing income from a portfolio faces different risks than a young physician accumulating wealth.
An entrepreneur whose livelihood depends on a single industry faces different risks than a pension fund.
Why should both begin from the same benchmark?
The burden should not be on investors to justify deviations from a proxy of a theoretical market portfolio.
The burden should be on every portfolio to justify itself on a case by case basis.
The Characteristics That Matter
Once passive and active labels are removed, portfolio design becomes a question of design constraints. Not virtues. Not identity markers. Constraints that shape what a portfolio can and cannot reliably do for a specific investor facing an unknowable future.
What characteristics increase the probability of success?
The answer depends on the investor. But the following constraints apply generally.
Liability-First Construction
Define what you must fund and when. Retirement spending, education timelines, debt obligations, emergency reserves. These are not goals in the abstract. They are liabilities with defined dates and amounts. The portfolio’s first job is to meet them with a high degree of confidence. Only residual capital should be exposed to aspirational or uncertain objectives.
Conventionally portfolios begin with a benchmark and hope the outcome suffices. The objective is not to match market returns, but to meet your future liabilities.
Specific Risk Budgeting
Diversification is not a virtue in itself. It is a tool. The question is: diversified relative to what risks?
A tenured professor with an inflation-linked pension and secure human capital faces different risks than a commissioned salesperson in a cyclical industry. The professor may reasonably concentrate in equities. The salesperson may need counter-cyclical ballast. Neither is “more diversified” in the abstract. Each is calibrated to offset their pre-existing risk exposures.
Deliberate Risk Acceptance
Know which risks you are choosing to bear, why you believe the expected compensation is adequate, and under what conditions you would reassess. Do not hide risk avoidance behind the claim that the future is unknowable. Uncertainty cuts both ways: excessive caution is also a bet, and it is often a poorly compensated one.
Real-world constraints often dominate abstract portfolio theory.
Mark Cuban sold Broadcast.com for Yahoo! stock in 1999, then faced a lock-up that prevented him from selling. He couldn’t diversify. The collar used to bound his exposure responded to that specific risk, not to whether it was called passive or active.
Maintenance Under Adversity
Assume you will be panicked, distracted, exhausted, or misinformed when decisions matter most. Do not design a portfolio policy that depends on optimal behavior. Design one that makes maintenance easy.
This means: rebalancing rules that execute when triggered, not when you feel calm. Spending rules that adjust mechanically, not when you judge the market fairly valued. Tax management that operates opportunistically, not when you remember to check.
The best portfolio is not the one with the highest expected return. It is the one you can actually maintain through the periods when judgment fails.
Transparency to the Decision-Maker
You must understand what each position does and why it is there, at a level sufficient to evaluate whether it still belongs. Complexity is acceptable only if its purpose is clear and its behavior under stress is understood. Simplicity is dangerous if it obscures.
A ladder of individual bonds may appear complex, but its cash flows, duration, and role in funding near-term liabilities are explicit. A single “balanced” or multi-asset fund may appear simple, but can obscure underlying exposures, embedded assumptions, and how it will behave across different market environments.
The criterion is not the number of positions; it is whether the investor can answer: what does this do, and under what conditions would I remove it?
Reversibility and Optionality
The future is unknowable. Your portfolio should not lock you into irreversible commitments based on unverifiable long-term forecasts.
Prefer liquidity when the illiquidity premium is uncertain, inaccessible, or unverifiable. Prefer strategies that can be modified as information arrives. Avoid concentrated bets that cannot be unwound without catastrophic cost.
Optionality is valuable precisely because the future is uncertain. A portfolio that preserves flexibility is not “indecisive”. It is appropriately humble.
Value-Aligned Costs
Costs are certain. Returns are not. All else equal, lower costs leave more of whatever return materializes for the investor.
But cost is not the only criterion. Pay for implementation when it buys something you cannot replicate yourself: access to genuinely illiquid markets, specialized expertise you actually need, or behavioral guardrails you would otherwise lack.
Do not pay for the illusion of expertise, the comfort of a brand, or membership in a tribe. Do not pay for “passive” as an identity when you can own the same exposures more cheaply yourself.
The question is not whether fees are low. It is whether they are exchanged for value.
Intellectual Humility
Perhaps the greatest benefit of abandoning the passive-versus-active framework is intellectual honesty.
Finance studies adaptive human systems rather than immutable physical laws. As a result, its theories are difficult to test, difficult to replicate, and subject to change once widely adopted. Its claims should be held to appropriately weaker standards.
Theoretical market portfolios cannot be observed.
Future returns cannot be known.
Risk cannot be reduced to a single number.
Every portfolio rests on assumptions.
Recognizing this does not weaken portfolio construction.
It strengthens it.
Investors become less concerned with defending labels and more concerned with examining assumptions.
They stop asking whether a portfolio is passive.
They start asking whether it is appropriate.
That is a much more useful question.
Conclusion
If every investment decision reflects assumptions about an uncertain future, then every investment is active.
The passive-versus-active distinction is not an objective law of nature. It is a classification system built around a particular benchmark and a particular theory.
Removing those labels does not leave us with chaos.
It leaves us with the real problem investors have always faced: how should a portfolio be constructed to maximize the probability of achieving its objectives?
That question is harder than choosing a label – many investors prefer the comfort of consensus to the burden of independent thinking.
It is also the only question that ultimately matters.
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