This is a guest post written by Rob Bennett, who blogs at A Rich Life. Although I can’t spend enough time on businesses that I’m not involved in to be a real “active” investor, I do follow major financial developments for my own enjoyment and this might be enough to tell when certain asset classes aren’t as good of an investment as they were in the past. Read on for Rob’s take on this!
Millions of middle-class workers are today wondering what happened to their retirement accounts. Investing in stocks wasn’t supposed to cause us to lose most of our life savings. There were studies showing that Passive Investing worked, weren’t there? There was historical data showing that, if we had to suffer through down markets, we would get the money back, no?
No. The historical data has never said any such thing. I’ve checked.
And, no, there are no studies giving any reasonable person cause to believe that Passive Investing (electing not to change your stock allocation even when prices go to insanely dangerous levels) could ever work in the real world. There are 30 years of studies showing just the opposite.
Given the extent of the losses we have suffered, there’s a temptation to conclude that we have all been taken in by a giant con. I don’t think that’s quite right either. I view that explanation as being too cynical.
It was all a great mistake. That’s the reality.
For many years, investors speculated about what was going to happen in the market over the next year or two and changed their stock allocations accordingly. That’s short-term timing.
There was research done in the 1960s and 1970s showing that short-term timing
does not work. This was breakthrough stuff. Lots of people got excited. A new model of understanding stock investing was developed. Passive Investing was born.
It wasn’t until the 1980s that we learned that we had jumped to a hasty conclusion in believing that not only short-term timing but also long-term timing do not work. The new research shows that 10-year stock returns are highly predictable and that long-term timing is REQUIRED for the long-term investor. You must lower your stock allocation when prices get out of control or you are likely to lose years and years of gain in a stock crash that may not come in a year or two but that is sure to come eventually.
Oops!
I can link you to scores of places where the new research is discussed. But rarely do
the big-name “experts” point out how critical it is to engage in long-term timing. A macho attitude prevails in InvestoWorld. The feeling is that any “expert” who acknowledges a mistake can no longer be viewed as a true expert.
Yucko!
The research that brought us Passive Investing is important research. Learning that short-term timing does not work truly was a breakthrough. But if we are going to turn investing into a science (and that is what we are doing when we use research into the historical data to inform our decisions) we are going to need to adopt more than the trappings of science.
Real scientists always remain open to new findings. Real scientists avoid dogma.
Real scientists don’t ignore their mistakes, they learn from them.
Passive Investing has failed us. It was a mistake. It has caused great human misery for millions.
It’s time to move on. This time, we need to encourage the Investing “experts” to
take a far more humble attitude in the presentation of their advice.
We know more today than we did 30 years ago or 50 years ago. But we still do not even come close to knowing it all. Let’s work hard as we try to pull ourself out of the wreckage of the Passive Investing avalanche not to repeat the oldest mistake of them all — forgetting that Pride Comes Before a Fall.
For more of Rob’s articles and postcasts, see his blog A Rich Life. What do you think – are you sticking to passive investing or trying to second-guess the market wisdom?
April 14, 2009 at 3:36 pm
One thing I would add to this is that not everyone can be successful by avoiding passive investing – it will always be the middle road between those who lose money and those who know better than the market. That said it currently appears that comparing the market to investment fundamentals could give you an advantage. If more people did that then passive investing would be more reliable because the market wouldn’t be driven by its own trends as much.
April 15, 2009 at 5:48 pm
I agree with that comment, siliconprairie.
What makes Passive Investing so dangerous is that a belief in it causes people to lose sight of where it is that stock market returns come from. The great paradox is that Passive generally works when not too many believe that Passive works, But, once large numbers come to believe that Passive works, look out!
Rob
April 20, 2009 at 3:58 pm
I think there are several concepts in this topic that I would define in this way for better clarity.
Buy and Hold vs Market Timing
Buy and Hold is where you try to hold your positions forever and this idea has been promoted by Warren Buffet.
Market timing is where one tries to enter the market for a rally and exit before a correction.
Passive Investing vs Active Stock Selection
Passive Investing is where one uses an index to capture the market risk of a certain market like using TSX Composite Index for Canadian equity market.
Active Stock Selection is that one tries to beat the market return by selecting individual stocks or using a mutual fund manager.
For example, I mix market timing with passive investing and active stock selection.
April 20, 2009 at 8:24 pm
Good points EconStudent. Even Buffet does sell stocks and companies though; if someone is offering you more than the present value of the future income using any reasonable assumptions that would be a good deal to take. Maybe you can buy it again when the price is lower – but if you think you can do better now by taking the cash and investing in something else that’s a good opportunity. In fact I’ve heard stories of entrepreneurs who have sold and bought back the same business several times, making a profit each time.
My goals isn’t to specifically buy at the start of a rally and exit before it goes down, but I do know that higher prices justify more selling and lower prices justify more buying.
May 7, 2009 at 12:57 pm
[…] Passive Investing — The Great Mistake Published in May 7th, 2009 Posted by Rob in Passive Investing I recently wrote a guest blog entry for the Silicon Prairie blog. It’s called Passive Investing — The Great Mistake. […]
May 7, 2009 at 1:46 pm
Bennett said:
You must lower your stock allocation when prices get out of control…
I can link you to scores of places where the new research is discussed.
Please do!!!!
May 7, 2009 at 4:53 pm
The research showing that valuations affect long-term returns dates back to 1981, Arnie. Rob Arnott is one of the leading figures in the field (he served as editor of the Financial Analysts Journal for several years) and he has said that we are soon going to see a “Revolution” in investing advice as a result of what we have learned from the academic research of recent decades.
The hold-up is that hundreds of millions has been spent promoting Passive Investing and those involved are uncomfortable (to say the least!) about the word getting at that most of what we have been told about how stock investing works for the last three decades is wrong. Since the huge price crash, however, there have been almost daily references to the discovery that the Efficient Market Theory is wrong and that Passive Investing cannot work in the real world. For example, Warren Bufett said just a few days ago that much of today’s conventional investing wisdom is “nutty.” That says it well.
I am in the process of putting together an article at my site that will provide scores of links. For now, I will report on the two statements that most impress me because they say things so clearly and boldly. Here is Arnott:
http://www.indexuniverse.com/publications/journalofindexes/articles/149-may-june-2009/5710-bonds-why-bother.html
Arnott: “The Conventional Wisdom of Modern Investing Is Largely Myth and Urban Legend”
Here is Jeremy Grantham:
Click to access JGLetter_4Q08.pdf
Grantham:”The dominant economic theorists so
valued orderliness and rationality that they actually grew
to believe it, and this false conviction became increasingly
dangerous.”
Rob
May 7, 2009 at 6:28 pm
Rob Bennett explains everything on his blog. He has about 100 hour-long podcasts, well worth listening to.
May 7, 2009 at 10:03 pm
Thanks for the links, Rob. Grantham had some darn good advice, I think, and I’m going to take it to heart:
Re-introducing the Very First of Our 7-year
Forecasts: Bullish Again!
Current Recommendations
Slowly and carefully invest your cash reserves into global equities, preferring high quality U.S. blue chips and emerging market equities. Imputed 7-year returns are
moderately above normal and much above the average of the last 15 years.
I was not as crazy, however, about Arnott’s proprietary approach:
Arnott, Hsu, Li, Shepherd, “Valuation Indifferent Weighting for Bonds.” Journal Portfolio Management, pending publication. Please note that there are U.S. and international patents pending on this work; we respectfully request that anyone wishing to explore this idea honor our intellectual property.
May 7, 2009 at 10:05 pm
So, even those those two weren’t exactly “Scores” of links, they were a good read, I suppose. However (and I may be a bit thick) I did not see where either of them necessarily buttressed your own arguments that Passive Investing is the evil doer of our current melt-down, and that it can be remedied by Actively timing the market. Can you take another stab at making that link clear for me?
May 7, 2009 at 10:17 pm
What do you think happens when millions of middle-class people are persuaded to invest according to an approach comprised of “myth and urban legend” that resulted from a “false conviction” that became “increasingly dangerous”, Arnie? They lose large amounts of their life savings.
Ours is a consumer economy. When middle-class workers lose a large portion of their life savings, they cut back on spending. That causes lots of business failures. That puts the entire economy in crisis.
I don’t blame the Passive Investing advocates for the mistake they made. I have made mistakes. We all have. I don’t see that as being at all a biggie. But I think it is essential that we get the word out about what really works. That’s the only way to turn this around.
People have lost confidence in the market, in our economic system and to some extent even in our political system. We restore trust by shooting straight with them again. We say what we know and, when we don’t know, we say “I don’t know.”
There is a feeling among a good number of “experts” that the worst thing in the world to do is to ever admit a mistake. I view this attitude as tragic. The only way to learn is by admitting mistakes. We have a lot to learn. We need to get comfortable with the idea of acknowledging mistakes.
That’s my sincere take re all this, Arnie.
Rob
May 7, 2009 at 11:03 pm
I just read the latest Grantham letter yesterday – he discusses a few more points related to market valuations and his strategy going forward (of course you have to be careful when someone who manages a lot of money talks about what they’ll do in the future, but I don’t think he expects masses of investors to follow him). It’s not scientific evidence but it does appear to be well-reasoned.
May 8, 2009 at 1:58 pm
You didn’t answer my question Rob.
Never mind, I think I can do my own research and come to my own conclusions. Based on my current information, though, I hardly think I’ll find Mom and Pop buy and hold investors to have been quite the scourge you have them cast to be. But then, I try to withhold judgment until the facts are in.
May 8, 2009 at 2:09 pm
It’s definitely best if you do your own research, Arnie. That way what you learn will make more of an impression. It will stick with you for the long term and that’s what matters.
I have all the sympathy in the world for mom and pop buy-and-hold investors. But it is fair to say that I believe that mom and pop buy-and-hold investors messed up and that they messed up bad. Lots of people are not going to tell you that. Lots of people are inclined to flatter you rather than to tell you straight that you and all the other mom and pop buy-and-hold investors caused the problem. I don’t play it that way. I do indeed say that we are all to blame.
The way in which I try to cushion the blow is to point out that by seeing what we got wrong we can turn things around and be assured that we will never have to live through this sort of thing again. The future is bright. IF we develop the courage to take a look at the man or the woman in the mirror and place the blame were it belongs. We were sold on a reckless investing strategy because we permitted ourselves to be sold on a reckless investing strategy. Others spent millions marketing this stuff but we are responsible for failing to protest when we saw it being done.
I’m grateful to you for the back and forth, which I believe has probably helped some people come to a better understanding of the issues at play. I of course wish you the best of luck with whatever investing strategies you elect to pursue.
Rob
May 8, 2009 at 2:26 pm
Rob,
This will be my last message to you, because it’s clear that you just don’t get it — there is no evidence that passively investing in broad indexes is somehow a ‘reckless’ strategy, especially given the alternatives. Yet you throw out terms like ‘reckless’ and ‘insane’ in an attempt to emotionally charge what is really a pretty simple proposition: can the average investor time the market or can’t they? All evidence *I* have seen is that they can not. If you have EVIDENCE that they can, I’m more than willing to look at it. Your strange need to bring every dialog back to this odd and frankly unconvincing and unsupported complaint you have is very disturbing, and so I see no upside to engaging you further on it.
May 8, 2009 at 2:44 pm
it’s clear that you just don’t get it
It might be that we just don’t agree re this one, Arnie. I “don’t get it” from your perspective and you “don’t get it” from mine. It happens. I certainly hope that we can remain friends despite our differences on this point.
there is no evidence that passively investing in broad indexes is somehow a ‘reckless’ strategy
There’s a mountain of evidence, Arnie. I’m certainly happy to acknowledge that there are millions of smart people who don’t today see this particular mountain. But I sure see it. And I am far from the only one.
Robert Shiller reports on what happens to investors who go with high stock allocations at times of insanely high prices in the Introduction (you don’t even have to make it all the way to the main body of the work) to his book “Irrational Exuberance.” We have been to a P/E10 level of 25 four times in U.S. history. The average price drop we have seen on those four occasions is 68 percent.
A 68 percent loss is a bone-crushing loss. We should not be telling middle-class people to invest in a way that causes them to experience bone-crushing losses. When large numbers of people experience such losses, it causes them to cut back on spending and that brings the entire economy to ruin.
The price you pay when buying stocks matters, just as it does when you buy houses or cars or comic books or bananas. The idea that we don’t need to protect ourselves from the effect of buying stocks at insane prices was a MISTAKE.
That’s my view, Arnie. I am not God or even a close approximation. Please feel free to adopt a different take. There are millions of smart and good people who have done so. But I need to tell my view and my view is that price matters.
Rob
May 8, 2009 at 3:05 pm
Ordinary investors may have contributed to the bubble by supporting unsustainable prices – that much is clear – but they aren’t to blame if they didn’t understand why that’s a bad thing. For those who don’t want to spend the time to figure out how the market works it can be better to just stick to a consistent plan and accept lower returns and a longer investment period.
Of course if experts could tell us exactly what to do that would be great, but it hasn’t worked out too well so far. Even if they started making more good calls there’s a bubble in something any time the majority of investors move in the same direction. In the end there isn’t really a “right” price so we need competing well-informed opinions to stabilize the markets, and as educated investors we need to decide for ourselves if we like the way it’s going.
For those who don’t want to understand every detail of their investments it would be helpful to make it common knowledge that when prices rise rapidly they’re likely to come down or at least slow for a while, but there’s no easy solution.
May 10, 2009 at 3:55 am
Interesting discussion here. I like EconStudent’s points about making those key distinctions. I’ve always said that if “passive” investing means not doing your research (ie., grab an index fund and don’t think any more about it), it’s not a good thing. So it’s important to define what we mean by passive investing. I’m a buy-and-holder, but I research my picks and try to “time” when I get into them, ie., when they’re on dips and seem to present good value. I track them over time so I can get to know their behaviour etc. too.
May 10, 2009 at 4:15 pm
For people who don’t want to understand what an index is based on, I actually like Ramit Sethi’s advice to buy lifecycle funds. A few of them are available from reliable index fund providers so at least the expenses are relatively manageable. It took me a while to understand why they would make sense for anyone but I guess that’s just me 🙂 Of course then there’s the possibility of these funds making adjustments for their investors but if more than one of the bigger ones tried to do this it would cancel out the effect.
May 11, 2009 at 11:27 am
“I actually like Ramit Sethi’s advice to buy lifecycle funds…”
I’d say for the large majority of investors, there could be no better advice.
In any case, it certainly beats giving up a rational, reasoned plan to follow some timing scheme proposed by one guy on the internet; a scheme which offers no specifics, no instructions, but merely denigrates everything else in sight. I can certainly do without that.
May 11, 2009 at 11:31 am
Oh, my.
Rob
May 11, 2009 at 3:10 pm
I’m pretty sure the large majority of investors won’t be reading this blog 🙂 I do feel good enough about my ability to spot big valuation problems that I’ll make some adjustments based on them, but as far as I’m concerned it’s definitely not for the average investor in the current situation.