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?

Advertisements

It’s been an exciting week, as I tried my new plan for active investments for the first time. After several months of browsing listings of websites for sale and ridiculing the majority of them, I found one that sounds reasonable and bought it for $1100. After some cash adjustments the price is less than 6 months of current profits, and I’m planning growth strategies now.

Even compared to the few active fund managers who actually add value (and who can never be identified until it’s too late) this is a great rate of return. It requires a bit of time and industry knowledge – it’s not really in my main area but it is related and I know the major trends – but even with the ongoing time input this has the potential to be my best investment yet (even if one of my regular contributions hit the stock market bottom and gets doubled this year).

The most exciting part is that I finally own an asset that I can improve by investing more time but that will continue generating income regardless of when I put that time in. Although I have employees in my main business I still need to be there every day and push it forward, which sometimes gets in the way of long-term improvements. This website only needs a little time to get each customer set up (and some occasional support), and then they keep generating revenue every month. Once it grows a bit I can even eliminate my involvement in the regular activities entirely.

The income might not be a lot but this is just the first step. Two years ago I opened a high-interest savings account and a bond fund and started putting in money even though I still had some credit card balances, because I wanted to get my passive income started. Now it adds up to more than any of my former interest charges did and I’m slowly growing it to much higher levels. This is the start of a new type of income and given a bit of time I’ll do everything I can to take it much further.

The results of this move will be very interesting, regardless of whether it’s a net loss or it produces enough profit for a larger investment. Are you looking at any opportunities to make extra money by getting involved in something directly?

A recent (long) post on Barry Ritholtz’ blog The Big Picture has a great chart (look for the 4th image in the post) that shows how uninvested cash in the US has grown to nearly the same value as the entire stock market, from an average around 40-50%. If a substantial portion of this returns to the market eventually it could raise prices well above their current levels.

There isn’t a particular reason that the peak of the S&P 500 is a special value and will be reached again in the near future (some estimates of long-term trends put the “right” value around 1100 rather than 1500). If there truly are many people waiting to invest again that does increase the potential future returns for anyone who gets in before them. There have been many stories about fund outflows over the last year so it’s not hard to believe that people have withdrawn temporarily to cash and bonds.

An important counterpoint is that with stock market declines of around 50-60% from their peak and this chart showing cash as a percentage of total stock market value, the actual amount of cash outside stock investments may not have risen that much. The fact that a good portion of this cash wasn’t invested in stocks before the crash means that it may not go into stocks once investors regain confidence.

This isn’t enough to change my plan but contemplating the fact that a lot of people may yet regain their enthusiasm for stocks reinforces the point that even if there are future declines this isn’t a bad time to invest.

Buying and selling assets at the correct price is important to all investors. Despite some widespread beliefs it’s easy to go wrong even in large markets. This affects all investors, as index investors want to avoid buying assets that have little chance of good returns in the future and active investors want to find opportunities to profit. Based on some recent reading I’ve started to draw conclusions about second-guessing the market that apply equally to indexers and stock pickers.

As I’ve written about earlier, the efficient market hypothesis doesn’t match what we can easily observe. I just read a post on the How to Make 7 Million in 7 Years blog, where the author disagrees with  Larry Swedroe about the reality of efficient markets. The points it brings up expand on my previous post about career risk. Some money managers may suspect that they’re not doing the best thing but go along with it so it looks like they’re doing a good job. That’s not the only reason for mispricing though.

The “efficient market” price of an asset is based not on information about the asset but on people’s assumptions and conclusions regarding that information (“prices will never go down”, “prices can keep rising 10% per year no matter where you’re starting from”). As Robert Shiller and several behavioral economists have documented, people can easily come to the wrong conclusions and these mistakes can be contagious. In this case you can look at the same information and decide that everyone else is wrong; if you’re right it’s a chance to make a profit or avoid a loss.

There’s a few common elements in many cases where the market isn’t efficient, even if you don’t know the future. Apart from a lack of understanding of risk and a belief in a new world (like the famous quote from a japanense investor in the 80s who said “we’ve moved to an entirely different way of valuing stocks”), the biggest thing linking these cases is the fact that people lose sight of what investment means.

When you invest you are simply giving up control of your money now to get more later. This comes in many forms but you always need to be paid for taking on risk and inconvenience. If an investment isn’t doing this in one way or another then it’s not really an investment. On the other side, if you’re getting paid and not taking on any risk or inconvenience then you don’t know what’s really going on. Aside from validating investments this also allows you to compare them. You can find the minimum that you should be paid to give up control of your money for a period of time with no risk. You can see increasing levels of returns as the risk rises, and decide if the added value compensates you.

Although guesses about future risk may vary (the meaning of risk often isn’t clear but I’ll have more about that later), the biggest mistake is to forget how to invest. If the whole market goes crazy and people temporarily make profits from doing the wrong thing you can join in and hope you get out on time or decide to look for investments that actually give you what you want. If you decide to participate it will be nothing more than blind speculation; that can’t be called investing.

As an index investor this principle is very useful in deciding on an asset allocation. To invest in an asset class I need to understand what I’m being paid for, how much I’m being paid, and reasonable expectations for future changes in the payments. If an asset class doesn’t meet the basic expectations for any investment then it shouldn’t be in my portfolio. I can then compare different asset classes to find the right mix; this principle might lead me to decide that I still want an asset class but my expecations of future returns are different and I need to change my allocation.

Just sticking to this basic principle should provide warnings about asset classes that are severly overvalued or undervalued and help adjust my allocation over time. If you prefer more active investment you can seek out markets where this principle isn’t being applied and try to profit from the fact that people will eventually lose interest in whatever ideas drove them away from common sense. Preferences for stocks, bonds, industries, and countries may change over time but the basic facts of investing don’t – ignore them at your own risk.

Recently the Canada Mortgage Trends blog had a post discussing the current economic environment with the author of one of the most influential studies on fixed and variable rate mortgages, Dr. Moshe Milevsky. He brings up some interesting points such as how you can calculate the breakeven interest rate for deciding between different types of mortgages (where’s the online calculator for this?). It seems that variable rates may no longer have the same advantage that they did in recent history, something I’ve started to suspect.

One of the things that jumps out at me is the discussion of short terms – even going as far as calling a 5-year term “long”. With the number of people who can’t renew their mortgages at the end of the term now, and the probability that interest rates can’t stay this low forever, I would hardly think of 5 years as a long term.

I recently read The Subprime Solution by Robert Shiller, which discusses some of the things done after the great depression. One of the surprising facts is that at the time many people had short terms for their mortgages, with less regard for matching the term to the amortization (apparently many people weren’t that concerned about when it would be paid off). With the increasing length of amortizations now this is sounding very familiar.

During the depression the US government created a new institution that gave lenders incentives to use longer terms and match them to the amortization instead of renewing and refinancing constantly. Many people seem to think this is the new way to finance houses, but if it’s caused problems before it may not be that great. I’ve been thinking that way myself – I don’t have much of a preference for a term greater than 7-10 years and will strongly consider a 5-year term if the rate is lower, but I have to wonder if I would be protecting myself from future risks well enough.

A short term could have advantages if it means you can negotiate a better rate due to a change in your situation later on, or you can take advantage of it to reduce the principal before renewing. However it’s always dangerous to take a short-term loan for a long-term liability, a lesson which has apparently been learned and forgotten in the past.

As always the only real solution is to consider your needs and think for yourself.

With all the personal finance blogs available now it’s not hard to learn that an easy way to secure your finances for the rest of your life is to earn more than you spend and invest regularly in stock and bond index funds. By investing 5-10% of your income throughout your career you’ll have a good chance of being able to afford a comfortable retirement after 30-40 years. The results of this approach are a very reaonsable definition of being rich. Although many people spend a lot of time and effort trying to do better than this – for example by finding investments with higher returns – it’s difficult and often backfires.

Still, some people criticize this plan because they think it’s too slow. Although they may be impatient they can’t do much about it because you can’t simply modify the formula to get 50% annual returns and carry on as usual (unless you’re willing to bet everything on very unlikely events). In truth, this approach is one half of the only two reliable ways to get rich.

If you follow this plan it’s simple to predict what will happen. With real stock market returns of 6-7% (maybe a bit lower if you want to have a high bond allocation) and monthly investments over a long period you can calculate how much money you’re likely to end up with after some time. You can then use a safe withdrawal rate to figure out how much income you can generate from your portfolio.

Most people don’t have much control over the factors that influence the results – the rate of return, the amount invested, and the time period. If you don’t want to wait a long time, the only option is to change one of the other two factors. For reasons that are discussed endlessly in many places the rate of return won’t vary much just because you want more, which leaves the amount invested and the best way of getting rich quickly.

The plan looks very different if you invest a much larger portion of your income. You can see this in two ways – either as trying to invest 40-60% of your gross income, or planning to draw a much lower income from your portfolio than you receive at the time you’re investing (in truth both need to be done). The simple fact is that readily available investment returns only allow two possibilities. You can invest a small portion of your income and wait a long time until your porfolio can match it, or you can invest a large portion of your income and expect your portfolio to provide even less than the remaining amount (but you may not have to wait very long).

Investing the second way doesn’t work for most people because they spend a large portion of what they earn, which means they can’t invest much of it or live on a significantly lower income. To do it without living a very minimal lifestyle you also have to work aggressively to increase your income. If you can keep your expenses low while rapidly increasing your income and giving yourself more investment capital you may have a shot at living off your portfolio much sooner than most people can.

Although it’s difficult to do, this is one of the few ways to get rich that doesn’t contradict simple math as well as economics and the entire history of investment. The time you have to invest before you can live off your portfolio is determined by the amount you put in, the rate of return, and the amount you want to get out of it. To get big results you need to make big changes to one of more of those factors.

It’s a common principle of investment that returns have to come at a cost – whether it’s having your money locked in for a period of time or risking a loss. Due to many economic forces any investments that have a good chance of producing higher returns without more risk, work, or inconvenience typically don’t last long enough for the average person or even someone who manages billions to get access to them.

It’s even difficult to pay someone else to do this, given the poor performance of money managers at all levels. Diversification is often brought up as the only way you can get higher returns without more risk. Like it or not, this means that most investors who don’t want to dedicate a large part of their life to managing their investments can’t expect to do better than the market average for their chosen asset classes.

However, a possible exception to this recently came to mind. I receive emails periodically from an investment management company that serves institutional investors. Just for fun I signed up for their regular long-term asset class forecasts, which never fail to indicate how much they expect to outperform the index in each class through active management. I can’t take the index forecasts or the active management expectations too seriously, but after receiving the lastest one I started thinking about it.

It’s virtually impossible to find a money manager guaranteed to beat an index by a significant amount consistently. It seems that no salary can buy better talent – someone always has to lose if there is to be a winner, and it changes every year. So what’s the back door? Career risk – which is discussed frequently in the emails I get.

Blindly following the market wherever it goes and taking extra risks along the way is the surest strategy to lose money, so to get above-average returns consistently you need to do things that virtually everyone disagrees with at times. For an individual investor this can be frightening and it’s difficult to hold your position when you constantly act against conventional wisdom.

For an institutional investor it’s far worse however. If you follow the market (find a hot asset, borrow everything you can, and buy in!) and get bad results you can at least say that you couldn’t forsee problems. If you go against conventional wisdom and don’t do well you’ll never get a second chance. This is the core of career risk. Whether it’s for job security or emotional security the majority of people would prefer to do poorly than to act on their own investment decisions and have better chances.

The great thing is that if there are money managers or mutual funds that consistently act against the current market “wisdom”, career risk will keep many investors away from them and leave the opportunity open to those who can see it. They are in fact risking their own careers by doing this. If they don’t perform they have no excuses.

Of course if they demonstrate exceptional returns over a long period of time people will eventually start to listen to them. Past performance seems to drive a lot more investment decisions than reasonable expectations of future performance. But until that happens, career risk may be the only way besides luck to have your money managed by the best before they’re “discovered”. That is if you can stand everyone you know thinking you’ll wind up broke for a decade or two.

Even mutual funds that attract large numbers of performance chasers can follow a cycle after they’re discovered – new money floods in, returns diminish or the strategy produces a couple of bad years, and the fund returns to its original size. Simply holding such a fund for a long period would give you much better results than the average fund flipper.

I still plan to be 100% indexed for the forseeable future, but this seems like one of the ways I may eventually be able to find a truly competent manager to increase my returns.