Print
Category: Newsletters
Hits: 4341

Beware the passive-ists – they bear false gifts

Passive investing proponents hold on to the belief that advice is irrelevant. One merely needs to invest in an index. I refer to this class of believers as “passive-ists”.

Lately, I am seeing with increased frequency many articles, newspaper articles, even forum comments all concluding that passive investing clearly outperforms active investing because it is cheaper. And that mathematically and empirically, cheaper investments always do better.

Such reports are accompanied by charts of comparing various investments to, usually, a stock index of some sort. The chart, of course, always shows the index in the lead. The accompanying article would also include a calculation indicating if you dump your financial adviser and save 1% a year, you will save thousands of dollars over your lifetime and your portfolio will be guaranteed to outperform everyone else.

Sheer rubbish of the worst kind, I say.

It looks like another outbreak of cognitive dissonance[1] has broken out once again. It is similar to the belief that American real estate could never, ever go down in value and that banks really have no need for collateral on a mortgage because a house, any house at all, could be sold or foreclosed for that matter, at an enormous profit because a house’s rise in value was infinite.

Unfortunately, the sub-prime collapse and subsequent housing collapse of 2008 destroyed the widespread cognitive dissonance of the time along with a trillion dollars or so of real estate values. The existing “beliefs” and “truths” were completely and utterly destroyed. Millions presumed that residential real estate could never fail. The U.S. Financial Crisis proved them wrong. What was oblivious to millions of homeowners became immediately obvious to all.

Investing fads come and go. Nobody wanted to be in the S & P 500 index when it dropped -57% five and a half years ago but right now, everyone wants to be in that same S & P 500 stock index today merely because it is cheaply traded, can be traded on a smart phone and according to the press, we can manage our life savings entirely by ourselves without any help.

The truth is the do-it-yourself investors will abandon the index investments in a panic liquidation during the next financial, political, economic crisis as easily, quickly and cheaply as they had acquired them in the first place. These “no-help” investments will cut the deepest as cheapness, in the end, has a price. That price may be your retirement, the family’s life savings or a relative’s portfolio you were managing. And the very last thing you will be thinking about is how much money you saved.

Currently, investors are pouring billions of dollars into index-like investments. Buy and hold strategies used to refer to long term investments like mutual funds that were held for many years. Today, long term means 20 minutes. The collapse of trading commissions – practically almost zero these days – means that we can buy and sell investments using our smart phones, cheaply, instantly and with scarcely a thought.

That’s the scary part, buying and selling investments without thought.

Active investing refers to investing with an adviser. Passive investing usually refers to investing in some sort an index-related investment.

It is true that when a stock market index is soaring (like right now), active investing with an adviser is sure to lag. All advisers know this but the press or other “experts” somehow have acquired beliefs that advisers should match or beat the index at all times.

This is where the affliction called cognitive dissonance comes into play. This affliction or disorder affects many people - even really smart people that should know better. Most unfortunately, but most obviously, some “experts” base their charts and tabular numbers, spreadsheets and assume (without giving much thought) that 100% of all investors will receive 100% of the return of the index 100% of the time. They conclude that a fee (any fee) by an adviser will commensurately and absolutely reduce the rate of the return by the identical amount.

What sheer lunacy!

The “experts”, writers and journalists overlook the obvious; do-it-yourself investors have and always will actively mismanage their passive investments and therefore, investors will not achieve index returns as they trade in and out of the investments. In the long term (the last 20 years), the average rate of return is almost at the bottom of the scale. It is scarcely that of cash. And no, the difference in numbers is so vast that we can not blame mutual fund fees or MERs! See this astonishing chart below:

http://blogs.marketwatch.com/thetell/2014/08/13/1-chart-shows-just-how-badly-average-investor-lags-even-cash/

Invesco, a well known and respected Canadian mutual company, says it is having difficulty finding value in the lofty stock markets and are expecting to build cash reserves. Invesco could be right or wrong but they are quite happy to keep some cash in reserve for better bargains (perhaps after a significant stock market correction?) Will they underperform the index while investors pile in at the tippy-top of the market? Yes they will.

At the time of writing (September 2014), the index is soaring to all-time record highs. Millions of investors are pouring hot money not into actively managed mutual funds, but into index-like products that emulate the benchmark indices.

Are the markets euphoric or merely complacent? Will bonds plummet in value when interest rates are set to rise once again? Do clients have too much stock exposure? We have not had a normal 10% stock market correction since 2011. Volatility has been quiet for some time – maybe too quiet.

I think it would be prudent to do a portfolio review and start exploring some of these questions.

Call your adviser today!

[1] Cognitive dissonance: technically it is a psychological condition, but in modern usage it usually refers to “being oblivious to the obvious”.