Passive investing and market volatility: why the calmest investors aren't the bravest
- Robin Powell
- 1 day ago
- 10 min read
During periods of market volatility like the one we're living through right now, the investors who stay calmest aren't the ones with the strongest nerves. They're the ones whose passive investing approach doesn't ask them to make decisions.
It's a Sunday evening in March. You know you shouldn't check your portfolio, but you do it anyway. You've been watching the news about Iran, the oil price, the falling markets. You open the app, see red everywhere, and your thumb hovers over the 'sell' button. You don't press it. But the fact that you thought about it is the point.
You're not alone in that impulse. Since the US-Israeli strikes on Iran began on 28 February, the VIX volatility index has spiked above 27 and the MSCI AC World is down roughly 3.9%. According to FE fundinfo, more than 95% of funds in the Investment Association universe have lost money since the conflict started. The urge to do something feels rational. It feels responsible.
It isn't.
'Trading is hazardous to your wealth.' — Barber & Odean (2000)
Brad Barber and Terrance Odean studied around 66,000 US households over five years and found that the most active traders earned annual returns of just 11.4%. The least active? 18.5%. The gap wasn't caused by bad stock picking. It only appeared after trading costs. As Barber and Odean put it in their landmark 2000 paper: 'Trading is hazardous to your wealth.'
So if acting on the urge to sell is so costly, why do so many investors keep doing it? And why do some seem to ride out turbulence without flinching?
The answer is less about psychology than you'd think. When an aeroplane hits rough air, pilots don't grab the controls and start hand-flying. They trust the autopilot. Not because they lack skill, but because in turbulent conditions, the fewer choices you make, the fewer chances you have to make a bad one. The same applies to your portfolio. The investors who come through crises best aren't the bravest. They're the ones whose investments don't ask them to fly manually.
The difference is design. And the evidence behind it is stronger than most people realise.
The behaviour gap costs more than most investors realise
Morningstar's Mind the Gap report, updated in 2025, puts a precise number on the cost of bad timing: roughly 1.2 percentage points per year. Over a lifetime of investing, that's about 15% of potential returns quietly disappearing.
The concept is simple but powerful. Fund returns measure what you'd earn if you invested once and held. Investor returns measure what people actually earn, factoring in when they buy and sell. The difference is the behaviour gap, and it reflects real, money-weighted outcomes, not theory.
The more investors traded, the worse they performed.
The culprit isn't fund selection. It's cash flow timing. Investors pour money in after strong performance and pull it out after losses. They buy confidence and sell fear. Morningstar is blunt about this: the more investors traded, the worse they performed.
What's frustrating is how persistent the gap has been. It's narrowed slightly from earlier periods, when it exceeded 1.5%. But even with cheaper funds, better platforms, and far wider access to passive investing, it still sits at around 1.2%. Decades of financial education haven't solved it.
UK investors fare better than most, but the trend is worrying. Morningstar's most recent cross-country breakdown (using 2023 data) found the UK gap was approximately 0.32% per year, the lowest of six regions studied. That sounds reassuring until you look at the direction.
An earlier study showed UK investors actually adding value, with a positive gap of 0.27%. The latest shows them destroying it. UK equity funds carried a gap of roughly –0.40%; fixed income around –0.26%. The gap is smaller here, but it's moving the wrong way.
One finding stands out. Funds with more volatile cash flows, meaning more investor trading, show larger gaps. Funds with stable flows show smaller ones. That pattern points to something beyond willpower. Something built into the products themselves.
Why 'just don't panic' is bad advice
The problem with most market volatility advice is that it targets the wrong thing. 'Stay invested.' 'Don't look at your portfolio.' 'Think long term.' All of it assumes the investor is the weak link. But telling someone to stay calm while their investment is generating reasons to act is like telling a pilot to hand-fly through turbulence and just concentrate harder. The better question is why the controls are in their hands at all.
Active funds don't just hold stocks. They produce a steady stream of manager commentary, sector opinions, and performance narratives. During calm markets, that feels like insight. During a crisis, it becomes a prompt. The manager has a view on what's happening. The fund is positioned for a particular outcome. The investor reads the update and thinks: should I be doing something too?
That sense of agency is the problem. It makes action feel productive.
Sector and thematic funds are worst. Morningstar's Mind the Gap research found these carry behaviour gaps as high as roughly 1.5% per year. And it's easy to see why. Which sector should you be in? When do you rotate? When do you take profits? Every one of those questions is a fork in the road, and every fork during a selloff is a chance to crystallise a loss.
Barber and Odean's research points to overconfidence as the engine behind all this trading. Investors don't act because they lack information. They act because what they own makes them feel informed enough to respond. The information itself becomes the trigger.
Yes, active funds can occasionally outperform during falling markets. But as TEBI has covered extensively, that marginal downside protection is patchy and overwhelmed by persistent underperformance when markets are rising, which is most of the time.
That sense of agency is the problem. It makes action feel productive.
What passive fund investors actually do differently
Passive fund investors trade less, hold longer, and steer clear of speculative stocks. The reason isn't temperament. It's that the products they own don't give them much to do.
The most direct evidence comes from a 2021 study by Catherine D'Hondt, Younes Elhichou Elmaya, and Mikael Petitjean, who examined how retail investors behaved when they held passive ETFs. Using propensity score matching on data from a Belgian online brokerage (covering January 2003 to March 2012), they compared 512 investors who held passive ETFs with a matched control group who held only individual stocks. The matching controlled for financial knowledge, education, portfolio value, and experience, so the differences can't be written off as 'well, those investors were just more sophisticated'.
The findings were clear. Passive ETF holders had lower portfolio turnover, larger portfolios, and kept their assets for longer. They were also better protected against stock gambling. The more committed the investor, the stronger the result: those who allocated more than 75% of their portfolio to passive ETFs, following a core-satellite approach, were the least likely to hold lottery-like stocks.
Now, this is Belgian brokerage data from one country and one time period. Fair to ask how far it travels. But when US system-level data and live UK flow data tell the same story using completely different methodologies, the triangulation matters. Three geographies. Three approaches. Same conclusion.
At the market level, Vladyslav Sushko and Grant Turner documented in a 2018 BIS Quarterly Review paper that index mutual fund flows are less volatile during periods of market stress than active fund flows. Passive money, in aggregate, is stickier when things get rough.
The explanation is straightforward. A global index tracker doesn't send you quarterly letters about sector bets. It doesn't invite you to second-guess the manager's positioning or wonder whether you should switch to a different theme. The autopilot keeps the aircraft level, not because the passengers aren't scared, but because there are fewer controls within reach.
That's what the academic research tells us. The system-level data shows us why it matters so much, and just how dramatic the gap between passive investing and active investing behaviour can be.
The autopilot keeps the aircraft level, not because the passengers aren't scared, but because there are fewer controls within reach.
The architecture of calm: how simple funds enforce discipline
Target-date funds don't just reduce trading. They virtually eliminate it. And the evidence holds even when markets are falling apart.
Vanguard's How America Saves 2025 report tracks participant behaviour across its defined contribution plans. In 2024, just 1% of investors in a single target-date fund initiated a trade. Among self-directed investors, those picking from a menu of funds themselves, 11% traded. An eleven-fold difference in a normal year.
But the real test came in 2020. The pandemic crash was the sharpest drawdown in a generation. Self-directed investors spiked to a 16% trading rate. Target-date fund investors? Four percent. The design held under extreme stress. As the chart below shows, this pattern has been remarkably stable since 2015, with TDF investors barely registering on the trading scale even in the worst conditions.
The consistency shows up in returns too. Five-year annualised return dispersion for single TDF investors was just 4.3 percentage points. For self-directed investors it was 11, ranging from 2.2% to 13.2% per year. When everyone owns roughly the same simple thing, outcomes converge. When everyone builds their own portfolio, they scatter.
And scatter they do. TDF investors cluster tightly in age-appropriate equity allocations, exactly where you'd expect them. Self-directed investors are a different story. Among them, 24% hold extreme portfolios, either 0% or 100% in equities. For younger self-directed participants, 17% sit at 100% equities while 5% hold none at all. These are the portfolios that breed panic when markets drop 20% in a month.
Automatic enrolment compounds the picture. Plans with auto-enrolment run a 94% participation rate, compared with 64% for voluntary plans. Total savings including employer contributions: 12.1% versus 7.6%. Employees with more than ten years' tenure in auto-enrolment plans have median balances roughly 60% higher than their counterparts in voluntary schemes. The architecture doesn't just protect behaviour during crises. It improves outcomes across the entire savings journey.
Morningstar's Mind the Gap 2025 report confirms this from a different angle. Investors in allocation and multi-asset funds captured roughly 97% of total returns. Fewer decisions, fewer mistakes, more of the return captured.
TDFs aren't flawless, and it would be dishonest to pretend otherwise. For investors who retire early, the glide path can become too conservative while the investment horizon is still decades long, reducing equity exposure precisely when growth is still needed. And at the end of that glide path, investors face exactly the kind of complex choice the fund was designed to avoid: what now? The simplicity is partly borrowed, not permanent. But the principle these products demonstrate is sound, and the data behind it is overwhelming. The autopilot isn't infallible. But it's far safer than hand-flying through the storm.
How UK investors are responding to market volatility right now
The academic research and the US system-level data both point the same way. But what's happening in the UK, right now, during this specific crisis?
The flow data is telling. According to Calastone's Fund Flow Index, active equity funds have been in outflow for 14 consecutive months. Passive equity funds have continued to attract net inflows. In February, as the Iran strikes began, net equity outflows totalled roughly £927m, the worst since November 2025. Those outflows were concentrated overwhelmingly in active funds. Passive equity kept drawing money in. The gap between active selling and passive buying predates the conflict. It's continued straight through it.
The Investment Association's most recent published figures, covering January 2026, show the same split. Active equity redemptions hit approximately £3.1bn. But index tracker demand was strong enough to push overall retail flows into positive territory at +£484m. The best-selling sectors were telling: volatility managed, corporate bond, short-term money market, and gilts. Investors were rotating into diversified and defensive positions, not running for the exits.
Platform-level data adds colour. AJ Bell reported that between 2 and 6 March, there were twice as many buys as sells across its AJ Bell and Dodl platforms. DIY investors were buying airlines and housebuilders on the dip. And here's a detail worth pausing on: Fundsmith Equity, the UK's best-known active fund, was among the least popular names that week. The same fund that attracted billions when markets were rising is now being avoided during the drawdown. That's the performance-chasing cycle in miniature, playing out with an active fund, not a tracker.
Hargreaves Lansdown has been running editorial content titled 'Iran conflict: the investment case for doing nothing'. No reports of exceptional client redemptions. The messaging is about staying the course, not managing a rush to sell.
No UK platform has reported panic selling in passive investing products since the Iran strikes began. The picture across Calastone, the IA, and the major platforms is clear: an ongoing rotation from active equity into trackers, multi-asset funds, and defensive assets, with the conflict reinforcing trends that were already well established rather than triggering anything new.
What this means for your portfolio
The calmest investors aren't braver. They've simply engaged the autopilot.
Think back to that Sunday evening. The app open, the screen red, your thumb hovering. The instinct to sell felt urgent. It felt rational.
But here's what the evidence from Belgian brokerages, US retirement plans, UK fund flows, and decades of behavioural research all says: the investors who come through periods of passive investing market volatility with the best outcomes aren't the ones who white-knuckle their way through. They're the ones whose portfolios never asked them to make a choice in the first place.
The lesson isn't emotional. It's architectural. You don't need more discipline. You need investments that don't test it. Simple, diversified, low-cost passive funds. Multi-asset or target-date structures if you want fewer choices still, keeping in mind that target-date funds have their own limitations if your retirement timeline doesn't follow the standard script.
And if you're feeling the pull to act right now, pay attention to that. The urge itself is useful information. It may mean your portfolio is built in a way that invites too many choices. That's not a character flaw. It's a design problem. And design problems have design solutions.
The calmest investors aren't braver. They've simply engaged the autopilot. And the best time to do that is before the turbulence starts.
Resources
Barber, B. M. & Odean, T. (2000). Trading is hazardous to your wealth: the common stock investment performance of individual investors. Journal of Finance, 55(2), 773–806
D'Hondt, C., Elhichou Elmaya, Y. & Petitjean, M. (2021). Does holding passive ETFs change retail investors' trading behavior for the better? Working paper
Sushko, V. & Turner, G. (2018). The implications of passive investing for securities markets. BIS Quarterly Review, March 2018
One logical next step
If this has made you think about whether your current approach to investing is actually working, our Find an adviser directory is a good place to start. Everyone listed has publicly committed to low-cost, globally diversified investing — the kind of approach that reinforces what you've read here, rather than quietly undoing it.
Stay connected: YouTube | LinkedIn | X For advisers: Connect with Robin about content
