I’ve heard a lot of talk lately about the issue of investors and investment advisors who claim to be investing “passively” but are really just actively managing low-cost index funds. One reason this issue is interesting is that most research into the superiority of index investing seems to ignore it completely.
For example, when Jack Bogle says the passively-managed Vanguard 500 index fund has to outperform all actively managed large cap funds after taxes and fees, he’s making a very specific (very true) claim: that a dollar invested at the start of a period in the Vanguard 500 will outperform (after taxes and fees) the average performance of a dollar invested in every actively managed fund. If all passive investors together earn the performance of the market minus fees, then all active investors together must also earn the performance of the market, minus taxes, fees, and trading costs. This is mechanically true, not an ideological argument of any kind.
On the other hand, the relative performance of the same dollar is completely unknown if you’re buying into the fund every time it goes up and selling every time it goes down, or vice versa. Even though you’re investing in a passively-managed index fund, if you’re actively trading it’s impossible to predict your relative performance compared to “passively” buying and holding an actively managed fund!
With that in mind, here are 3 kinds of activity that are guaranteed to change your performance relative to the market, one way or another.
Active fund selection
Say that you are committed to investing exactly $1,000 each month in a low-cost, passively-managed index fund. However, each month you decide from scratch which fund to invest in. Some months you think the domestic stock market’s overvalued and you invest in a total international stock fund instead. Other months you think the domestic stock market’s got a lot of upside potential so you buy in there instead. Other months you see that below-investment-grade bond yields have ticked up and buy $1,000 of that fund instead.
I suspect if you really feel compelled to introduce some kind of activity into your investment decisions, this is the most defensible: you’re consistently adding the same dollar amount to your investments each month, you’re investing in low-cost, passively-managed index funds, and you’ll end up either modestly underperforming or modestly overperforming a truly passive approach.
You still shouldn’t do this, but I find the impulse completely understandable.
Active timing of buying decisions
An approach that is much more likely to see you underperform over time is timing your buying decisions. There are a number of ways you might execute such a “strategy.” In a single-fund portfolio, you might wait until the price/earnings ratio drops below some fixed number before buying, or you might wait until some arbitrary drawdown from the fund’s high point before adding additional funds.
The two biggest problems with this approach are the certainty of missing out on dividend yield and the likelihood of jamming yourself due to tax considerations.
For the first point, consider that the Vanguard 500 at its current price yielded 1.89% in dividends over the last 4 quarters. I am absolutely positive that the Vanguard 500 will experience at least one 10%, 20%, and 50% correction in the next decade, but I am completely agnostic as to whether they will occur tomorrow or 10 years from today, which means I’m completely agnostic about the level from which the drawdown will occur, which could easily be 11%, 25%, or 100% higher than today.
The second point is even more devastating if you’re making contributions to a tax-advantaged account with annual funding limitations. Say you can make 2017 contributions to your IRA on any date between January 1, 2017, and April 16, 2018. You would obviously like to make your purchase on the date within that period when your contribution will purchase the most shares possible. The problem is that each day that elapses is a day when you’re unable to make your purchase, even if it turns out to have been the cheapest entry point. When April 16 comes around, you’re forced to make your contribution, even if it’s the absolute most expensive point during the year, and you’ll meanwhile have missed out on 5 quarterly dividend distributions.
Active selling decisions
The absolute worst kind of activity you can introduce into your account is selling activity. I do not consider this to be because of tax consequences, because I think tax consequences are utterly irrelevant for most investors and wildly overblown even for the small group of investors they do affect.
The problem with selling activity is that it requires you to be right twice: you have to correctly guess when the price of a fund will drop, and exit before it does so, and then you have to correctly guess when it is at or near its bottom in order to reenter before it rises again (or guess when some other fund will start to rise).
The one kind of selling that makes any sense is rebalancing from appreciated assets to less-appreciated assets within a tax-advantaged account. For example, a 50/50 domestic/international portfolio may naturally change its weight to 60/40 if domestic stocks drastically outperform international stocks. I don’t think you should do that, but I understand the logic behind it if you have some reason to be invested in a 50/50 portfolio to begin with.
What is a passive investment portfolio?
There are two ways to construct a truly passive investment portfolio:
- Make regular, identical purchases of a fixed asset allocation, and never change it.
- Make a single purchase of a fixed asset allocation, and never change it.
As an example of the first, you might contribute a fixed dollar amount to a single domestic index fund every week or month. As an example of the second, you might make a single purchase of a fund or set of funds and never buy or sell them again.
Both choices have their advantages and disadvantages: the first will give you access to the range of asset prices across several business cycles, allowing you to buy in at the average value of each asset class. The second gives you access to more dividend distributions by making your contributions up front, but locks in your cost basis at the moment you make your single initial investment decision.
While both are fine, I believe only a tiny minority of investors are capable of pursuing either option. If, like most investors, you aren’t able to behave completely passively, you need to decide what kind of activity to introduce into your portfolio.
- Actively selecting passively-managed low-cost funds that you’ll hold forever is unlikely to present much of a drag on your portfolio, since you’ll be fully invested at all times in whichever funds you ultimately pick.
- Actively timing buying decisions isn’t a great idea, since you’ll find yourself with investable cash on the sidelines while you could have been accumulating shares that provide a stream of future income.
- But actively selling shares is virtually guaranteed to make you underperform basic market indices all year, every year.
A final option is to “top up” underperforming investments with each new additional investment, so rather than selling off overperforming funds in order to buy underperforming funds you might make larger contributions to the underperforming funds until they return to their “ideal” allocation. This is still market timing, but perhaps the most harmless of all forms of market timing if you insist on introducing activity into your portfolio — which, to be perfectly honest, you probably will.