Tuesday, May 05, 2009

Passive Investing Is a Strategy for Extremists

This is a guest post by Rob Bennett, of a Rich Life. You may also be interested in my detailed critique to this post. If you are interested in publishing a guest post on Money and Such, please contact me at shadox1 at the domain name gmail.com

By temperament, I’m not an extremist. I like to work hard and I like to take vacations. I’m a saver, but I don’t entirely deny myself the pleasures of modern-day middle-class life. I enjoy it when I can fit in regular exercise. But I’ve never been willing to push it hard enough to finish first in a race. I usually am happy finding my way to the moderate middle.

When it comes to investing, however, I have been called an extremist on more than one or two or three occasions. Is it something I said?

I think that it might be.

I have said that Passive Investing (sticking with the same stock allocation at all price levels) is “reckless.” I have said that Passive Investing “can never work in the real world.” I have said that Passive Investing (but not the many smart people who follow it) is “insane.” Yikes! I do sound a bit over the top, don’t I?

Maybe I should take it back.

But --

I can't.

It’s certainly true that in a relative sense my views on Passive Investing are “extreme.” I hate Passive Investing. I believe that the popularity of Passive Investing is the primary cause of the economic crisis we are living through today. I think it would be fair to describe me as the most severe critic of the Passive Investing model alive today. However, in an objective sense, I don’t believe that my views are extreme at all.

My take is that it is Passive Investing that is extreme. It is because I dislike extremism that my distaste for Passive Investing is so strong.

Passive Investing advocates tell us that it is not necessary to make any changes in our stock allocations in response to big price changes. Stocks were selling at three times fair value at the top of the bubble. Even at those prices Passive Investing advocates were telling us that it made sense to put a big percentage of our retirement money into stocks.


That makes no sense to me.

I have looked at the historical data to determine how much investors should be lowering their stock allocations when prices go as high as they went from 1995 through the first part of 2008. The data shows that prices had gone roughly that high on three earlier occasions in U.S. history. The average price drop in the following years on those three occasions was 68 percent. I cannot afford to lose two-thirds of my retirement money in a price crash. So the idea of having a high percentage of my retirement money in stocks at a time when such a price crash is all but inevitable makes no sense to me.

I can see an argument for having 20 percent or 30 percent of your money in stocks even when they are selling at such high prices. Short-term performance of the stock market is unpredictable. So, even when stocks are selling at insane prices, there might be upswings that you would want to participate in. However, I can’t see putting more than 30 percent of your money at risk of the huge price crashes that always occur from those price levels.

Is that thought the thought of an extremist? Or is that the thought of a moderate?

I say that it is the voice of a moderate. I say that it is the idea that we should not even consider the idea of making allocation changes in response to big price changes that is extremist. We all should have been debating the different possible options all along. Some might have argued for zero percent stock allocations at those price levels, others for 25 percent stock allocations, others for 50 percent stock allocations. That would have been healthy. That way we all could have heard the arguments for all the possible viewpoints and decided for ourselves what stock allocation made sense for us.

That debate never took place. The popularity of Passive Investing took the idea off the table. Most “experts” said that no allocation change at all was needed and most otherwise moderate middle-class investors went along.

Taking the most important strategic question off the table before discussions over it began was a bad idea. 

The word “passive” sounds neutral. It sounds moderate. I don’t think the investing philosophy is that at all. The investing philosophy argues for taking no action whatsoever when the risk of holding stocks increases dramatically. I suppose it’s fair to say that that’s one point of view re how investors should respond to price changes. I don’t think it’s fair to call that particular point of view a moderate one. Making no allocation change at all at all price levels is extreme.

It’s like with the people who say they love everybody except for the people who hate everybody. I favor moderation in all things except for investing philosophies that are anything but moderate. Passive Investing strikes me as the most extremist investing philosophy around. I hate it.

Rob Bennett writes the “A Rich Life” blog. His “The Investment Strategy Tester” shows investors how they can recover all of their recent stock losses by converting from the Passive Investing strategy to a valuation-informed strategy.

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Ren said...

I'm not disagreeing with your observation, but I wanted to mention the mitigating effect of rebalancing. Rebalancing during the rise in stock prices results in a large increase in non-stock holding, quite probably larger than would be achieved by simply having a larger allocation to the non-stock holdings in the first place.

Of course, buying in at or near the peak completely misses this benefit.

One aspect I think is often ignored in the passive investment strategy is that it is not only as you get older that you need to make your allocations more conservative. It is also anytime your short-term needs are not fully funded. As long as you have enough conservative investments to get you through the next ten years or so -- assuming realistic expense and income assumptions -- then you can afford to be more aggressive with additional investments.

Rob Bennett said...

Thanks for your comment, Ren.

When I put forward this sort of argument, people often respond by pointing to the benefits of rebalancing. Rebalancing does help. I certainly do not say different. But I very much question whether rebalancing is enough to do the job.

I have a calculator at my web site that uses a regression analysis of the historical stock-return data to reveal the most likely 10-year return on stocks starting from various valuation levels. At the valuations that applied in 1982, the most likely 10-year annualized real return was 14 percent. At the valuations that applied in 2000, the most likely 10-year annualized real return was a negative 1 percent. What stock allocation makes sense both when the likely long-term return is a plus 14 and when it is a negative 1?

The problem with rebalancing is that it leads people to believe that they are doing something in response to price increases while not doing nearly enough. Someone who properly chooses an 80 percent stock allocation when the likely long-term return is 14 percent real should probably be at a stock allocation of 20 percent or less when the likely long-term return is a negative number. Those who rebalance are by intent going with the same allocation at all sorts of wildly different valuation levels.

Rob (author of the guest blog entry)

Manshu said...

Very well written. I am myself not sure when it became gospel truth that Passive Investing is ultra safe, but, I hear it a lot. However, what are your thoughts on passive funds beating active funds most of the time?

Shadox said...

Manshu, Ren - I think you will be interested in my critique of this post which I added today.

Rob Bennett said...

what are your thoughts on passive funds beating active funds most of the time?Thanks for your kind words, Manshu.

To respond, I first need to distinguish the term "passive" from the term "indexing." I think indexing is wonderful. To buy an index is to obtain huge diversification at low cost. That makes all the sense in the world. To invest passively is to stick with the same stock allocation regardless of price. That makes no sense at all (at least not to me).

I understand that these two terms are used synonymously all the time. I certainly mean no criticism of you in pointing out the distinction. I think that one of the problems that many have had in seeing the flaws of Passive Investing is that these terms are confused.

I generally like indexing. I don't think it is for everyone. But I think that most middle-class investors are better off in indexes. Picking stocks effectively really does take more effort than many of us are willing to put into it. I advocate an approach called "Valuation-Informed Indexing."

The studies you are referring to do not stand up to scrutiny. What they usually do is compare the results of mutual funds with the results of index funds. Mutual fund managers are not free to pick stocks to the best of their ability. They need to market the fund and that means doing what impresses potential buyers of the fund. That means taking a short-term perspective rather than a long-term perspective. Not good.

The way to assess whether stock picking works is to see how independent and informed investors do at it. Those who know what they are doing and who do not feel marketing pressures to invest for the short term generally do better than indexers, in my assessment.


Anonymous said...

Rob Bennett said:
"The studies you are referring to do not stand up to scrutiny. What they usually do is compare the results of mutual funds with the results of index funds. Mutual fund managers are not free to pick stocks to the best of their ability."

So, is it your thesis, belief, and counsel that managers who pick individual stocks outperform those who use indexes? If so, I think you stand alone.

Rob Bennett said...

is it your thesis, belief, and counsel that managers who pick individual stocks outperform those who use indexes? It depends on their level of independence. Those who are both independent and well-informed can do well. Those who need to pay attention to marketing concerns (this is most mutual fund managers) don't stand much of a chance, in my assessment.

If so, I think you stand alone.By not stretch. There are thousands and thousands of smart investors who pick stocks effectively on a daily basis. I don't think stock picking is a good idea for the typical middle-class investor. It takes a lot of work. But it can generate a good payoff for those willing to put in the time and work.