Passive Investing is for Extremists: The Critique

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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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.

Huh?

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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Building Workplace Alliances

They say that "no man is an island", and that statement is just as valid in the corporate world as it is in the rest of the world. In fact, no matter how talented you are as an employee, a professional or an executive, you cannot be successful unless you learn to build the relationships, alliances and the coalitions that will help you to achieve the results you need. 

Understanding the Machinery - to build and manage effective coalitions, you first need to understand how your organization works. Who makes the decisions? Who delivers the data? Who influences the decision makers? How does information flow? If you have been with the organization for a while, chances are that you have a good sense this structure. If you are the new guy on the block, make learning the machinery of your organization your number one priority.

First, Do No Harm - the first step in getting someone to join your cause is to ensure that this person does not consider you a pain. If you think that someone's support, approval or even mere consent is critical to what you are trying to achieve, make sure that you are not standing in their way, and that you are not causing them a headache. As a simple example, if you think you need support from some of the guys at accounting for a project you are working on, don't be the guy who they think of as a pain in the neck for failing to submit his expense reports on time. It's as basic as that. Similarly, if you are known as the guy who vocally criticises any proposal that is brought up by someone else, folks will be practically chomping at the bit to kill your own initiatives.

Reciprocity is the Key to Success - expanding on the previous point, people will be much more inclined to help you if you have already shown a willingness to help them. For example, I have recently turned down an offer of additional resources from my CEO to help support one of my projects, in favor of those resources being directed to a key project run by our VP of Operations. Last week, when I pitched a new project to my CFO in a staff meeting, the VP of Operations spoke up in support of this plan, without my having to request this.

Building Support in Advance - here is the cardinal rule of alliance building: 

Do not surprise your allies and supporters. 

If you want someone's assistance in a key task or you need their support for a major initiative, prepare them in advance. Don't spring this request on them in a crowded room... you might not like the answer you receive and the dynamic that develops might turn against you. This is why God invented the pre-meeting... arrange pre-meetings with key potential supporters and rivals in a 1:1 setting prior to pitching your initiative to the full group. Get their opinions, hear their objections, listen to their criticism. Worst case, you will know what to expect. Best case you will have assured yourself of support even before your idea has been formally introduced. The main meeting should be nothing more than a rubber stamp. The real work should be done in advance and behind the scenes.

Start Early - people find it much harder to object to programs which they have had a hand in developing. For this reason, involve as many people as you can in the early decision making process (preferably in a 1:1 setting, again). Make a conscious effort to accept as many of their suggestions as you can, while still ensuring that your underlying goal remains intact.

Acknowledge Success and Give Credit - nothing creates more good will than giving credit where credit is due, and sharing praise where praise is deserved. Last week, our engineering team delivered an impressive and successful demo - a major milestone for our company. My CEO was not present at this demo, so during our executive staff meeting later that week I made it a point to congratulate the VP of Engineering on his team's impressive success, in front of our CEO. I was not being hypocritical and I was not kissing up. I was speaking my honest opinion, and I was doing it in a setting that placed the credit exactly where it was due, and gave a fellow executive an important win in front of his boss. Presto, good will created.

If you are able to design and build the right coalitions for each of your initiatives and major projects, you will find that your wins are much easier to come by and that your victories happen more frequently. That can only be a good thing for your career.

Here are a few more career related posts from around the PF community:

Frugal Zeitgeist - my good blogger friend - has continued and extended the discussion I started regarding a sense of entitlement in the work place. Did I already mention that Frugal Zeitgeist is a blog I read daily?

Dana of Investoralist also picked up on the same topic, and shares some opinions about Gen Y in the work place and in life.

Finance your life was working this weekend in hopes of a promotion later this year.

Money Smart Life offers some good advice on preparing for a pink slip.

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Career Clinic: Posts & Questions Please

I have come to the dismal conclusion that PF bloggers don't write enough about career development. This is a shame, since for most people their career is their biggest financial asset and most important source of income.

So, with that in mind, I am happy to announce the Money and Such Career Clinic. 

What: 

I will add a link on Money and Such to any career related post that I can find or that is sent to me by any PF blogger.

I will answer career related questions that I receive from my readers or from anyone else that cares to send me one (I don't know how many I will receive, but will at the very least respond by e-mail with an answer to anyone who sends in a question). Some of the good questions and answers will be posted on Money and Such (together with any relevant links).

You can contact me by sending an e-mail to shadox1 at the domain name gmail.com.

When: 

Monday, May 11th. Please send me any submissions by Sunday afternoon (Pacific Time). 

Who: 

I don't have a lot of reach, so I am asking my blogger friends to help me drum up some posts and questions. Come on, write one post about career development, work place dilemmas, finding a new job, dealing with a bad boss, or any other career related item that comes to mind.

All submissions welcome, but I would like to specifically encourage some of my regular readers and blogger friends to contribute, including Digerati Life, Frugal Zeitgeist, Investoralist, Plonkee Money (would be nice if you could help me get some other folks to write some posts as well).

Let's see if this is of interest to anyone...

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Career Ending E-Mails

E-mail is the bane and the savior of the modern office worker. On the one hand, we are inundated by an endless stream of seemingly useless messages that we really don't want or need. On the other hand there has never been a faster or more efficient way to exchange information quickly and interactively between large groups of people. This post is about how to use corporate e-mail in a way that will help, not hurt, you in the office.

On the Record - whatever you say in an e-mail is there forever. It is recorded by your company servers and can be pulled back at will, whether or not you try to delete it. This means that e-mail is not a form of communication you should be using if you have a problem with any third parties being able to view your message at some point in the future. For example, anything that could jeopardize your organization's business positions or cast it in a bad light simply should not be communicated through e-mail.

E-Mail Makes the Rounds - Last week my CEO forwarded me an e-mail thread, in which older messages included some highly sensitive information that was clearly not meant for me to see. In that specific case, the information did not concern me and I will be keeping it in close confidence, however, be aware that people hit the "reply all" and "forward" button all too easily and something that you meant only a friend or specific colleague to see is now plastered across the entire e-mail system. Watch what you say. 

Along the same lines, when you refer to someone in an e-mail use respectful terms. Don't call someone a jerk in an e-mail, even if you think they fit the bill. All too often that written record will find its way to the wrong hands. Treat e-mail exactly like you would a post on your open corporate website. 

Don't Be a Corporate Spammer - one of my direct reports in my last company used to account for 30% of my e-mail traffic. He used to cc me on EVERYTHING. If he was trying to schedule a meeting with someone, I would get copied on the entire thread, including all the time changes and discussions of where to meet. I guess he was trying to make me see that he was working hard. Instead he made me think that he was a semi-competent waste of my time.

Seriously, before you hit the cc button or reply to all button, think. Does everyone really need to see this e-mail? If you want your e-mails to make an impact, reduce their number.

Joke Forwarding - it's OK to forward the occasional joke or funny site. Just keep it in proportion, don't over load people's inboxes with junk and certainly make sure whatever you forward is appropriate for your work environment.

Understand the Medium - people often fail to realize that e-mail does not communicate tone very well. Consequently, something that would sound very innocent and non-confrontational given the right tone in a face to face conversation, can sound like a full frontal assault when written in an e-mail. Before you hit that send button, re-read your e-mail and make sure that your intention comes through even when the reader has a different mindset from your own. I frequently end up re-writing an e-mail to avoid possible misinterpretation after I re-read it. You know what, sometimes even that isn't enough. By the way, NEVER, ever send an e-mail when you are upset.

Here are a few other career related posts from around the PF blogosphere:

The Simple Dollar has a post about how work and personal life balance and what frugality has to do with it all.

The Smarter Wallet has a proposal for folks who have recently lost their jobs: start a business.

Squawkfox has a series of posts about resume writing, the latest of which talks about three popular formats.

Boston Gal has a post about different ways of handling unemployment. Well, actually it's a Boston Globe story, but it's still worth reading.

Digerati Life has a post about how to use social networks for career development.

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