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.
Just out of curiosity, why do you believe “only a tiny minority of investors are capable” of actually using a passive investment portfolio passively? Do you get lots of readers emailing you and saying otherwise? Is there some actual data out there that supports that claim?
I just wonder, because I’m part of that “tiny minority” and it seems completely asinine to not invest this way based on my, albeit limited, knowledge of how to properly invest. Maybe I’m skewed b/c I read a decent number of personal finance/financial independence/early retirement blogs, but it seems the overwhelming amount of advice “out there” on the interweb is dictating to be a part of the “tiny minority” and it would surprise me if people are reading that advice….and then not following it b/c they think they can do better. Or, like I said, maybe my perspective is skewed by reading those blogs and most people don’t have the same perspective resulting in them trying to “game” the system.
Ben,
So there are two issues: the percentage of funds which are actively managed, i.e., invested in funds that are run by a manager who actively manages them. That number was recently about 70%, according to this Morningstar report.
So it’s already true that a minority of investors (or more properly, a minority of invested assets) invest in passively-managed funds. To get to “tiny” minority actually using those passively-managed funds passively, I’m judging by what I read in the media and hear on podcasts every day, where there’s a constant deluge of information about the (active) strategies you should use to manage your investments in those funds.
Matt and I had an exchange on Twitter that provides another perspective: during a long bull market, it’s easy to stick to a passive schedule of contributions or watch your passively invested funds passively rise in value. But when the correction inevitably comes, a lot of people who are comfortably passive right now will become uncomfortable and active as they either sell to avoid the drawdown or buy to take advantage of it. I certainly think I will buy heavily when the next economic catastrophe strikes, but I don’t know for sure since it hasn’t struck yet!
—Indy
Hmm that’s interesting. Obviously that number is going to be skewed by rich people with huge amounts of money invested, but I don’t mind overlooking that. That number makes me sad, because it means people aren’t doing the smart thing with their money….but obviously that’s my opinion.
So if you’re going to “buy heavily” when the next “catastrophe” strikes (let’s hope it’s just a normal downturn and not a catastrophe btw), then are you doing exactly what your article seems to condemn…trying to “game” the system? I’ve kind’ve bought into the “slow and stead wins the race” mentality, and I doubt I’ll do anything different when a downturn occurs. Part of this is because I sincerely doubt my ability to “game” a system as complex as the market.
Ben,
Yep, unfortunately I too belong to the great bulk of investors constitutionally incapable of leaving well enough alone. What I do to protect myself from myself is to set up guardrails. For example, I never, ever sell, which protects me from panicked selling when the market goes down and anxious selling when the market goes up and “valuations are above their historical averages.”
Since all I ever do is add additional money, the worst that can happen is buying something that ends up underperforming my regular dollar-cost-averaged core portfolio (the Vanguard 500). But the best case scenario is I really do buy something when it’s cheap (I recently bought emerging markets) and it really does outperform over the next 30 years. I don’t think that’s especially likely, but I do think it’s relatively harmless.
—Indy
Here is where that logic breaks down a bit if I’m understanding your habits correctly.
To put out some numbers just for illustration. You regular invest $1`00 a month. If the market goes up, you continue in your regular pattern of $100 a month. If the market goes down (significantly?) you invest an extra $50 that month for $150 total.
Where did that $50 come from? If it was money that you can afford to invest, you only get the upside of that $50 if the market goes down. Sure when the market goes down you make even more money than normal when it finally rebounds but what if it never goes down enough for you to buy more? You will have lost the upside of that $50 investment and only enjoyed the upside of the $100 investment. It sounds like you are actually trying to time the market while saying that you aren’t. I agree that it’s probably the safest way to time the market but it’s still timing.
If you regularly invest $100 a month and then you get a $50 bonus that month and you invest that $50 into the market regardless of market swings, that would be a much more Boglesque way of investing. Sometimes that $50 will be invested right before the market goes up, sometimes right before the market goes down and sometimes in between but you aren’t timing the market. You are assuming that long term your $50 will be worth a lot more going forward in 30 years if invested in the market than if not invested. It may be factually wrong this time but it’s right a lot more often than it’s wrong.
I may be misunderstanding you, in which case forget what I said. 🙂
On the other point, I know a money manager who puts most of his clients into passive investments and avoids actively managing them. He tells his clients that his job is to talk you out of selling when the market goes down. He gets clients who call all the time panicking during the inevitable corrections saying they have to sell everything. Smart people who have built massive wealth can do very irrational things.
Oren,
Thanks for reading. Couple points: I did not mean to come across in this post as saying that I’m the perfect passive investor! I am absolutely not the perfect passive investor. My point is that when you understand the different kinds of activity you can introduce into a portfolio, you can recognize the more damaging versus the less damaging kinds of activity and, if you feel compelled to act, act safely instead of act dangerously. I have my regular dollar-cost-averaged contributions to my tax-advantaged portfolio and then, in addition, I plan to buy more aggressively during the next downturn.
The second point, “where did the extra $50 come from?” is a good one, and the answer is, it comes from nowhere. I can spin up or spin down an unlimited amount of cash each month, and if I see a good buying opportunity I’ll spin up an extra couple thousand dollars. In your analogy, it’s like I can pick when to receive my bonus. Now it’s true that I could spin up the cash today (pay myself a bonus today) and invest the cash immediately, but in the absence of a particularly ripe buying opportunity the cash is more valuable to me plowed back into my travel hacking, where I have a steady guaranteed return every month.
My core philosophy is that as long as you never sell, there are a thousand ways to invest successfully. Once you introduce selling into a portfolio, there are a thousand ways to sabotage your success.
—Indy
Your philosophy of “never sell” is probably an over-simplification (if not, I think it is flat-out wrong). Active selling is a very important and appropriate skill that every investor needs. We all invest for one or more goals (e.g. retirement, down-payment on a home, paying for kid’s college, etc.). Active selling takes into account the timeline to reach those goals and the fact that your investments should shift based on how close the goals are. When my daughter was born and we had 18 years before she headed to college, it was entirely appropriate to invest 100% of our 529 plan in equities. Now that she is 17 and we will need the funds starting next year, we cannot afford a significant market decline. Consequently. we have sold equities and purchased other assets that are far less likely to decline in the short term (and missed out on the “Trump bump” over the past few months). I agree that active selling based on market performance or timing is harmful, but active selling based on the timing of your goals is crucial.
Jamie,
You’re right that reallocating towards less risky assets as the date they’re needed nears is a different kind of selling, I shouldn’t have glossed over that. I discuss it more at length in this Saverocity thread: https://saverocity.com/forum/threads/why-hold-bonds-for-the-long-term.501069/
—Indy