Passive investing may not sound exciting, but it plays a crucial role in the financial system. But what exactly is passive investing in the context of DeFi? Simply put, it's the removal of human bias and emotion from the decision-making process of selecting and managing assets on the blockchain. And trust us, there is a ton of bias and emotions.
Active fund managers rely on research, intuition, and experience to select investments for mutual funds. Passive investing takes a different approach. Instead of relying on human judgment, it uses smart contracts and decentralized protocols to automate investment decisions. These protocols are governed by pre-defined rules and algorithms, ensuring a transparent and objective approach.
Similar to traditional index funds, on-chain index token (OITs) in DeFi often follow pre-defined rules defined by smart contracts. These OITs, that are like a decentralized ETFs, track specific indices or market segments within the blockchain ecosystem. Rather than trying to outperform the market, passive investors aim to mirror the performance of the chosen index or segment.
So how does one "own the market" in Web3? Owning the market in this context means participating in the blockchain ecosystem as a whole, rather than trying to outperform it. For example, a passive investor may choose to invest in a decentralized index fund that represents the overall performance of various cryptocurrencies or blockchain projects. By holding this diversified portfolio, they gain exposure to the growth and potential of the entire market.
Why would someone choose passive investing instead of trying to beat the market? Many proponents of passive investing believe that consistently outperforming the market is highly unlikely, if not impossible. In contrast, active investors may believe that they can identify undervalued assets and avoid poorly performing ones. However, it is important to recognize that in DeFi, the market itself consists of a collective network of participants, making it difficult for any active investor to consistently beat it.
The fallacy of the active investing argument becomes apparent when applied to DeFi: if all active investors were to beat the market, they would collectively become the market. In reality, transaction costs, fees, and the difficulty of consistently beating the market hinder the success of active investors. On the other hand, passive investment strategies implemented through smart contracts and decentralized protocols provide cost-effective access to market returns while avoiding the pitfalls associated with active management.
Moreover, passive investing in DeFi goes beyond cryptocurrencies. It can be applied to various blockchain-based asset classes, including decentralized lending and borrowing platforms, decentralized stablecoin protocols, and yield farming strategies. The versatility of passive investing in DeFi allows investors to focus on critical decisions, such as asset allocation and selecting the most appropriate passive investment vehicle, without the added complexity and costs associated with selecting individual assets.
While the preponderance of evidence suggests that passive investing outperforms active management in DeFi, there are still instances where active investing can be compelling. For example, in less liquid and opaque markets within DeFi, such as certain types of distributed credit or complex derivatives, superior analysis and active strategies can generate outperformance. However, such cases are the exception rather than the rule, as historical data suggests that sustained outperformance is rare.
In conclusion, passive investing in DeFi and blockchain technology represents a dynamic and vibrant approach to wealth accumulation. By leveraging smart contracts and decentralized protocols, investors can participate in the growth of the entire blockchain ecosystem. While active management may have its merits in certain situations, passive investing offers a cost-effective and efficient means to capture the market's potential in the decentralized financial landscape.