Yesterday Rob of a Rich Life posted what I thought was a thoughtful and well written guest post on this blog, making the point that passive investing is a fool's game. I would like make a few comments regarding this post and its underlying assumptions.
First, it's important note that the term "passive investing" can be defined in a number of different ways. I think of passive investing as investment in Index funds vs. stock picking or investments in actively managed funds. I have written numerous articles on the subject and academic studies indicate that for the vast majority of investors, and over the long run, index investing yields much better returns than do the actively managed alternatives. However, Rob is not differentiating between these different stock investment strateiges. His main claim relates no so much to how you invest in stocks, but rather to the percentage of your portfolio that is invested in this asset class, regardless of which stocks or stock funds you put your money into. I think that it is more correct to say that Rob is against passive asset allocation, than he is against passive investing as I understand it.
With that in mind, let's discuss the main point. The underlying assumption of Rob's post is that when stocks are overpriced, investors are better off aggressively under weighting stocks in their portfolio, and supposedly the opposite is true when stocks are under-priced. Essentially Rob is advocating a form of long-term market timing. While this may make sense in theory, I am not clear that it can be accomplished in practice. For one thing, short term market timing is notoriously difficult to get right. In fact, my post tomorrow will deal with exactly that issue. Why make the assumption that investors will be better at predicting the long term peaks and troughs in the market than they are able to predict short term ones?
Another important question that needs answering is what metric is used to determine whether stocks are overpriced or whether they offer good values. The price to earnings ratio is commonly used for this purpose, however that indicator is far from straight forward. For example, at the peak of the economic cycle, just as stocks are getting set-up for a fall, earnings are often at their highest levels, sometimes making stocks appear modestly priced. The reverse is true at the bottom of a cycle when earnings can be dismal. Valuing stocks by more complex models (cash flows, CAPM, or whatever else you may favor) adds layers of complexity and murkiness to the analysis - not to mention making it inaccessible to most of the population.
Oh, and one more thing. There is an entire industry of investment advisors out there that use sophisticated (and presumably meaningful) quantitative tools to make investment decisions. These professionals can move assets between stocks, bonds and often other asset classes. Some of them can even bet against the stock market by taking short positions. Do these guys do any better than the rest of the investment community? Nope. The fact that you have a quantitative model doesn't mean that it has any predictive power. Ask some of the hedge fund managers who got crushed in the recent meltdown.
I am not ruling out Rob's theory, although I think that he has a heavy burden of proof to overcome. I think that there are clearly very appealing aspects to his theory. However, I am not convinced that this theory can be put into profitable practice when everything is taken into consideration: transaction costs, potentially increased tax burdens, and most importantly the ability to correctly gauge whether the market is correctly valued. At the end of the day, investing in stocks over the truly long-haul will get you about a 6% premium above what you can get for putting your money into treasuries.Maybe you can come up with a better theory that will yield higher returns, but I am betting it's unlikely. I'll be glad to be proven wrong.
Here are a few other investment related posts I found around the PF community:
All Financial Matters is commenting on the performance of target date funds in light of a new SEC investigation. GenX Finance also looks at target date funds and shows off some numbers (Yikes).
My First Million is betting that the stock market rally will stall, he says "sell".
Weakonomics tells his readers to ignore the financial media and uses the current rally as an example. Also on Weakonomics, catch the latest Carnival of Personal Finance.
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