When you have to make a choice and don’t make it, that is in itself a choice.
~ William James
Update: This post was selected for the June 1st, 2010 edition of the Best of Money Carnival posted at Free Money Finance. Thanks very much! It was also featured in the Carnival of Financial Planning - Edition#144 posted at Free Money Finance. Thank you!
A lot of smart people advocate passive investing. Passive investors do not try to time the markets. They are usually buy and hold investors who set an asset allocation and rebalance periodically. They have a core belief that their investments will be profitable in the long term, which usually means 20 years or greater.
Many passive investors are adherents to the principles of Modern Portfolio Theory, and by association, the Efficient Market Hypothesis. I’m not so cracked on either myself, but there are some advantages to taking a passive approach to investing.
Advantages of Passive Investing
- It’s Less Work: Passive investors do not have to go to the trouble of researching and selecting specific stocks or investment vehicles in which to invest. They will often use ETFs (Exchange Traded Funds) or index mutual funds to buy an entire index or sector. Rebalancing makes buying and selling less frequent and more automated. Many passive investors use dollar cost averaging to buy regularly, thereby avoiding the decision about when is the best time to buy.
- Actively Managed Mutual Funds Rarely Beat the Index: Passive investing proponents often cite research showing that, over the long term, it’s almost impossible for an active manager to beat the market averages. As a result, they advocate simply buying the index through a mutual fund or ETF.
- Lower Fees: Index funds and ETFs usually have MERs (Management Expense Ratios) that are much lower than those associated with actively managed mutual funds. For example, the XIU (iShares S&P/TSX 60 Index Fund) is the most popular ETF for tracking the 60 largest companies in Canada’s TSX Composite Index. It has a management fee of just 0.17% per year compared to 2% or so for many mutual funds.
- Avoid Emotional Decisions: When you contribute to, and rebalance your investments regularly, you avoid selling into a panicked market or loading up on overvalued stocks at market tops.
Passive Investing vs. Index Investing
While some investors may contend that passive investing and index investing are one and the same, it’s probably more accurate to say that they overlap. Passive investors are a type of index investor. While most passive investors will make use of funds that track indices, not all index investors are passive investors.
Many index investors will adjust their portfolio allocation based on economic conditions, technical analysis, or market valuations. Some index investors will look only at one of these factors and others use a combination of them to determine their asset allocation. (For the record, I would probably fall into the latter style of index investing.)
Inviting one person from each approach to index investing to dinner would probably make for some pretty lively debate, although I can’t guarantee that a food fight would not ensue. Most adherents to each of these different approaches are absolutely convinced that their approach is the correct one, and many can produce endless statistics to back them up.
The Ostrich Effect
The most ardent passive investors will tell you to completely ignore financial commentary in order to avoid straying from your financial plan. I can’t bring myself to take that approach with our money. It seems to me that those who advocate this are falling victim to The Ostrich Effect, which is a behavioural finance term for investors who ignore risky financial situations by pretending they don’t exist.
The current financial upheaval has brought the ostriches out in full force. Passive investing purists are telling investors that they should ignore the sovereign debt crisis, the current macroeconomic challenges, the increasingly volatile financial markets, and anyone who comments on such things. They are confident that, in 20 years, the markets will be higher than they are right now. They often base this contention on historical data that shows that markets tend to rise over the long term, returning an average of 7% – 10% per year.
I’ve argued before that these historical returns are irrelevant to today’s market on the grounds that:
- The market structure has changed over the past couple of decades.
- Past performance is not a good indicator of future results.
I can’t agree with an approach to decision-making that encourages people to ignore new information. Sticking your fingers in your ears and singing while the markets tank is not a good investing strategy. Mind you, neither is running screaming out of all of your investments and hiding in your basement.
What If I’m Wrong?
In the face of so many conflicting views, it’s easy to become frustrated, throw up your hands and give up. I don’t claim to have the answers. Although I have my theories, I don’t know what the markets will do in the short term or the long term. Neither does anyone else.
Ironically, passive investors often use that fact to defend their approach. Knowing that they can’t consistently predict market movements, they claim not to try. As today’s opening quote denotes, however, choosing not to make a market call while remaining fully invested is in itself a market call.
Passive investors are betting (yes, betting) that markets will be higher in the future. Hence, they are in a sense gambling in a way that is similar to the market timers they often deride. They are just doing so with a longer time horizon. They may be right, but …
It seems like hard core passive investors are forgetting to ask themselves the question that is key to evaluating any decision: What if I’m wrong? Ignoring changes in market structure, macroeconomic fundamentals, and technical cues can be hazardous to your wealth. It’s always prudent to have a contingency plan, no matter how confident you are in your strategy. What if markets aren’t higher in 10 or 20 years?
I’m not advocating trading in and out of the market with your hair on fire. But I do think it makes sense to adjust your asset allocation according to market and economic conditions. In the current environment, it may be wise to pare back on risky assets like stocks and bonds (yes, bonds can be very risky too) when so many indicators are flashing a yellow light. Increasing your cash position is the easiest way to reduce risk.
Mohamed El Erian and Bill Gross of Pimco have been saying for some time now that the current market environment is one in which we need to be more concerned with the return of capital than the return on capital. I happen to agree with them. You may disagree, and I can respect that. Completely ignoring what they and other smart market commentators have to say, however, doesn’t seem like such a great idea.
Do you agree with the passive investing crowd or not?