The Case Against Passive Investing

————————————————————————————————————————
Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
————————————————————————————————————————

The following is a guest post by Rick from Invest In 2012. Enjoy! 

The Case Against Passive Investing 

I’m not much of a passive investor myself, as I like to get in and out of markets within just a few weeks. But with all due respect, I do know some people who are wealthy and are also passive investors. So, taking their opinions into consideration, here’s my case against passive investing.

As a trader, passive investing is unappealing to me in two ways.

1) Your portfolio rises and falls with the markets. Naturally, I want every single one of my trades to be profitable, so I can’t stand following the market’s ebbs and flows.

2) Patience has never been a big virtue of mine. I might be able to wait up to a year for the right opportunity to come along, but no more than that. I can’t just watch my portfolio sink 30% in one year. I feel like I have to do something about it.

But a lot of people are passive investors because they simply don’t have the time to invest actively. Fine. But still, I don’t think passive investing is very effective. Here are it’s flaws.

Advocates of passive investing often cite the “over 40 years, the stock market moves up”. That sounds great, but if you think about it, who can hold on to an asset for 40 years? Even 30 years seems like a stretch. Most passive investors and mom and pop investors don’t hold for 50 years; they hold for 10 at most. The reason why markets fall and rise in extreme volatility is because it’s very painful to hold onto a stock for 10 years and not realize any gains, so passive investors are lulled into selling at market lows!

And even if passive investors do intend on holding a stock for 40 years, many of them simply can’t! While some people have the capacity to ride out an economic storm and buy on the dips, the majority of Americans can’t. The next time the recession hits, or the next time they’re out of a job: they have to make ends meet at home. Considering that the American savings rate is so low, the only way to rustle up some instant cash is to sell their equities portfolio! And as chance has it, you’re most likely to be out a job at the bottom of a recession, when (non-coincidentally), stocks are also at market lows. Talk about bad timing. Passive investing asks you to buy when the market dips. And when the market dips badly, unfortunately, most passive investors (who work at a job during the day) don’t have any cash to buy!

Also, stocks (just like everything else in this world) have cycles, usually lasting 15 years. Fifteen years of good times, and 15 years of bad times. So what happens if you get out of college, land a job, plan to start investing, but the beginning of a 15 year recession hits? You’d have to have the stomach to hang on during those 15 years and not see any profits! There’s going to be a lot of really scary market crashes, which is why the end of a market crash is usually signalled by the panicked selling by a lot of buy-and-holders (no offense to the buy-and-holders out there).

So let’s assume that you are a passive investor, and you’ve actually had the guts and the capability to sit back and hold on to your portfolio for 30 years. Now, you’re 57 years old, and close to retiring. All of a sudden, the country plunges into a recession, and BOOM, 50% of your retirement fund is wiped out in a flash. At your previous annual growth rate of 7%, how long would it take for your portfolio to climb back above pre-crisis levels (adjusted for inflation)? A long time. Hence, it is not surprising that soon-to-retire passive investors were among the hardest hit in the 2008/2009 financial crash. While the young guy still has 20 or 30 years to grow his retirement fund, the soon-to-retire guy doesn’t!

For every market winner, there’s a market loser. For every dollar made, there’s a dollar lost. Warren Buffett once said “If you don’t know who the fool in the game is, it’s probably you.” If a laid back, passive investor is making money, who’s the one that’s losing?

And above all, as a passive investor, your fate is in the hands of the market. You’ll be completely exposed to the ups and downs of the market.

How about you all? Do you follow a passive or active management style in your investing strategy? Why do you choose one method or the other? 


Share your experiences by commenting below!

Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.

  • Thanks for this insightful guest post, Rick! Even though I’m pretty devoted/convinced passive investor myself, I always like to hear different perspectives.
  • My thoughts on the various arguments mentioned in the post are listed below: 
    • Since I realize that I have a fairly biased perspective on this topic, I welcome any and all feedback in the comments section below! 
  • However, before we get started, I just wanted to point out that passive investing (at least as I have learned it) does not actually involve buying and holding individual stocks. Instead, this is avoided by purchasing shares of index mutual funds or ETFs that represent the entire market through a target asset allocation.
    • With this distinction in mind, let’s continue.
  • @ Reason #1 why passive investing is unappealing -“1) Your portfolio rises and falls with the markets. Naturally, I want every single one of my trades to be profitable, so I can’t stand following the market’s ebbs and flows.”
    • While it’s absolutely true that with passive investing, you do have to bear the ups and downs of the market in a controlled way (through a target asset allocation – more on this in a second), this argument is not convincing to me because history has shown time and time again that it’s HIGHLY unlikely that an individual person (or even investing professional) will have the foresight to make money 100% of the time on their trades, or even a high enough percentage of the time to make enough to stay ahead of the market returns over long term periods. 
    • I’m not going to say that this never happens (i.e Peter Lynch, Warren Buffet), but it is rare, and it’s even harder to predict ahead of time who these investing magicians will be.
  • @ Advocates of passive investing often cite the “over 40 years, the stock market moves up” –
    • From what I’ve seen so far, I do not believe you need 40 years in order to realize the benefits of passive investing over active investing.
    • Sure – a long period of 20 years may be needed in order to realize the historical average return of the stock market of around 10%, but I simply am not convinced that by using active trading, you can guarantee that you will make that kind of return either. 
    • Thus, the main benefit (in my mind) of passive investing over active investing is that it saves investors from being their own worst enemy because history has shown that people are not able to time the market and/or buy and sell individual stocks in a way that enables them to beat the market return.
  • @ “Most passive investors and mom and pop investors don’t hold for 50 years; they hold for 10 at most. The reason why markets fall and rise in extreme volatility is because it’s very painful to hold onto a stock for 10 years and not realize any gains, so passive investors are lulled into selling at market lows!”
    • I had two general comments that came to mind when reading this portion of the article.
    • First, I think that my experiences have been fundamentally different than that described above. I know people that do hold on to index mutual funds in their retirement accounts for very long term periods, and so I am convinced that people have the resolve to do so. 
    • Second, while it is true that the markets do rise and fall in a volatile nature, as a passive investor, the risk you expose yourself to is done so in a manageable way (in my opinion). 
      • How is this done?
      • Easy – through target asset allocation percentages. 
      • By choosing a mix of index investing instruments from different asset classes ranging from volatile (equities) to more secure (fixed income securities), you are able to control how much risk you expose yourself to. 
      • For example, if you are the 57 year old soon-to-be retiree and are using an intelligent life cycle asset allocation plan recommended in any quality passive investing book, you will have no where near 100% stock exposure at that point in your life. Thus, you will not lose 50% of your assets overnight because the majority of your money will be in fixed income assets. 
  • @ “And when the market dips badly, unfortunately, most passive investors (who work at a job during the day) don’t have any cash to buy!”
    • Two arguments for this statement:
    • First, one could say that this reasoning applies to active stock picking too. If the market is going down and your stocks have dipped as well, you’re not going to have excess cash either.
    • Second, the overall goal of passive investing is to maintain a set/target asset allocation at any one time between various asset classes (fixed income, real estate, equities). 
    • So, in the case of a market dip (a big decrease in equity prices), what would actually happen is that your fixed income and other asset classes would become too large a percentage of your portfolio. So, what you would do is actually sell those shares to buy more equity shares during the dip. In this way, you wouldn’t be drawing upon new money in order to buy more equity shares.
  • @ “Also, stocks (just like everything else in this world) have cycles, usually lasting 15 years. Fifteen years of good times, and 15 years of bad times. So what happens if you get out of college, land a job, plan to start investing, but the beginning of a 15 year recession hits? You’d have to have the stomach to hang on during those 15 years and not see any profits!”
    • Personally, I have never heard of recessions lasting 15 years. 
    • For example, let’s say that you landed your first job and started investing right when the recession started around Summer 2008 (actually, this was when I got my first job out of college).
    • If you used typical dollar cost averaging in order to invest money in your retirement fund in passive investing instruments each month, it would not have taken too long at all to start seeing a return on the shares that were purchased at very cheap prices during the market bottoms of March 2009, etc. 
    • In other words, I don’t think that it takes 15 years to see results from following the periodic investing strategy that most passive investors employ when saving for retirement. 

***Photo courtesy of http://www.flickr.com/photos/twobears2/4252297559/sizes/l/in/photostream/

Comments

  1. “it's HIGHLY unlikely that an individual person (or even investing professional) will have the foresight to make money 100% of the time on their trades, or even a high enough percentage of the time to make enough to stay ahead of the market returns over long term periods. ”

    That's not entirely true. There are a lot of individual investors (not fund managers) who consistently make great returns. But you don't hear about them much because they like to keep a low profile.

  2. If you don't have the time or the skill to be an active investor what option do you have other than passive investing? And capital gains on your investment are only part of the equation for many buy and hold investors. The dividends are often a much more compelling passive investing story.
    My recent post Emerging Markets Diversity – Thai Stocks for Profits

    • Thanks for reading Money Infant. One option that people could do is to hire a money manager to trade stocks for them. Or, they could follow advice in a newsletter. Of course, both of these strategies rarely beat the market, hence why I like passive investing.

  3. I've never really been a fan of passive investing. It's a given that there are business cycles in the economy, so why not buy during a recession and sell during the boom? You might not be able to pick the exact top & bottom, but in the long run, you'll make a lot more buying & selling, rather than buying & holding until retirement. Just my 2 cents… 🙂
    My recent post Grab a FREE $20 from GoalMine – Super Easy!

    • That's a good point Kyle. Like you eluded to, the problem is that no one can correctly predict when these recessions occur and when to buy and sell. Instead of buying and holding shares forever, the strategy that employ dictates maintaining a set asset allocation between fixed income and equity securities. So, what this means is that if the stock market falls, you'll have to buy more in order to maintain your asset allocation percentages.

  4. Shaun @ Money Cactus says:

    I can see the logic, but I'm a lazy investor so passive works well for me. I'd much prefer to invest my money, walk away and have fun then come back sometime later to see how I'm going. Watching something closely wouldn't agree with me, I couldn't handle to volatility that often comes with short-term investments!
    My recent post Hyperbolic Discounting: Why your decisions are already made before you make them

  5. MyCanadianFinances says:

    Extremely interesting take on passive investing. I can see where you are coming from, but like a few who have commented I prefer passive investing.

    You nailed it when you said it is probably because most people do not have time to actively invest.
    My recent post How I Am Trying To Turn Everything Around

  6. GabrielOgata says:

    It’s a given that there are business cycles in the economy, so why not buy during a recession and sell during the boom? You might not be able to pick the exact top & bottom, but in the long run.

  7. I think there are passive investors who hold a stock for 5- 10 years but are still in the game.

    The other passive investors the ones that hold it longer are simply lazy, have fully forgotten about it altogether, fearful, believing that the stock that once was high but fell will go high again, or have just given up.

    I don't even consider them traders, nor would I put them into the same category as people who enjoy trading.
    My recent post Deciding What To Trade and Then Sticking To It!

  8. I think if you are comfortable with the risks then that is a good method. I like to take certain risks but higher dividends helps bridge the gap for a down market.
    My recent post 5 Tips Not To Be Nervous In A Photo Shoot

Speak Your Mind

*

CommentLuv badge