“If you push indexation to its logical extreme, you will get preposterous results” – Charlie Munger
Passive equity investing dominated investing styles at the close of 2021. This is highly typical following any decade of rising equity indexes, and even more likely after the spectacular returns of the biggest bull market of the last 100 years, as shown in the chart in last week’s Insight.
The chart below shows the remarkable scale of the shift in investment flows. Passive investing becomes so popular that for a time it becomes a self reinforcing factor in the market, as rising markets bring in more passive investors and continued growing wealth for existing passive investors. This is a necessary feature of every bubble, a bubble can’t happen without it.
For most investors, not much is more important than understanding whether passive investing really works. Clearly for a time it does, but that isn’t the appropriate analysis for an “all the time” strategy. The biggest issue is time horizon confusion. Passive investing means buy and hold for the very long term regardless of ups and downs in the markets. Passive investors need to consider an effective full cycle investment process to manage the inevitable downsides too. As we showed last week, the bubble bust has always come in the past.
By definition bubbles go to unsustainable levels. Bubbles are a form of long term instability and distortion and it is all too easy to make investment mistakes over the full cycle one way or another. The flows to passive investing are cyclical and allocation is indiscriminate.
“capital is not allocated accordingly to its marginal return but instead is allocated on the basis of market capitalization”
The flows of passive investing will accentuate any kind of momemtum particularly in large market capitalization stocks. The long term expected merits of stocks becomes an increasingly irrelevant factor as the flows of passive investing grows. Passive investors need to be aware that it is not an optimal asset allocation method, even though periodically it becomes dominant.
The chart below shows that the percentage of firms with negative earnings peaks with any bubble as investing becomes increasingly indiscriminate.
It is hard to find good advice about how to invest through a bubble. Bubbles come along only once in a while. So successful experience of the previous bubble is hard to find and usually advisors also get caught up in a bubble. In any case, usually some variation of passive investing is often what is advised by the investment management industry. However, is that really the best advice?
Investment manager’s rewards are linked directly to the amount and longevity of the investments in their accounts, and passive investing requires the least amount of asset management work as a long term holding period is recommended for the assets in your account. Not much work really needs to be done and its simplicity and effectiveness is popular as the bubble grows.
Unfortunately, there is a long term contradiction in this strategy, and passive investing quickly loses its appeal when the bubble pops, and passive investing becomes a pain trade. Investors end up selling when the pain of losses becomes too great.
How likely is it that you will find a credible alternative to passive investing? When most investors are consumed with the great returns from the upside period of the bubble? Who is going to get investors to focus appropriately on the outcomes for the long term through the full cycle?
Do you fully understand what passive investing means for you, not just now, but for the next 10, 20, or 30 years? Once you understand what this could mean, will you be able to stay the course? Do you really have an effective plan for when the bubble peak is past? Or will you share the experience of so many and lose most or even all of your gains and only then do the work you could have done it at a much better time?
So let’s get real clear about the history, math and behavior of passive investing. Is this really the plan you want?
Passive Equity Investing
When you look at the average outcome over the last 100 years, passive equity investing looks like a “solid” approach at the outset. The return compounds and the longer the time period the greater the return. Also, by using average returns for the different periods it gives the impression that the returns are always positive and consistently compound without any deviation.
Unfortunately, your actual experience will be very different from this picture in very important ways. If you bought at the highs in 2000, you would not have experienced a positive return for 13 years. It is much better to examine the worst you could have experienced through passive investing and consider whether you could manage yourself through something approaching this more adverse experience.
The chart below shows the worst that could have happened over each time period over the last 100 years. This was actually what passive investors would experience, albeit a worse case extreme. Passive investors need to be very clear about whether they could endure these outcomes and whether that would have been worth it even in the long term.
This data reveals the following conclusions:
Passive investors may need 20 years to be confident of a positive return.
Passive investors may need to hold their account through a 3 year 84% decline in value.
Looked at in this way, I believe that passive investing includes possible outcomes that very few investors would accept at the outset. There is a great risk that that passive investing will be abandoned after a considerable loss once adverse conditions are experienced. This would involve not just lost capital but also lost time.
Furthermore, for any investor with a shorter time horizon, say of 10 years or less, or any investor who requires capital preservation, passive investing is wholely inappropriate. The 10 year return has a very wide range of potential outcomes and luck plays a significant role in the outcome.
Passive investing is a behavioral phenamonen linked to past returns
Investor’s household equity allocations have followed the previous 10 year stock market returns very closely ever since 1945, as shown in my book. There is nothing new about bubble investing.
The consequence is that the maximum allocation is at the highs, while the lowest allocation is at the lows. This has been a consistent pattern for 70 years at least.
The great majority of passive investors, therefore, significantly underperform the index over their chosen long term horizon, because they adopt the strategy late in it’s development and then abandon the strategy at an adverse time when returns have already begun declining. This is what happens to most passive investors in a bubble.
In other words most passive investors have failed to reconcile at the outset the consequences of being a very long term holder and what that entails. Typically passive investors are late buyers in the up cycle and then late sellers in the down cycle.
This usually means taking a loss and leaving less time to compound returns on less capital. Make sure you avoid this problem with your investing. Don’t find out at the wrong time that you were a speculator, when you originally thought you were a long term investor.
The most succesful long term investors have been through this experience and found a way to manage it. Use their experience to avoid what happens to most investors. There are many steps to learning how to manage this, and one of the hardest for most investors is:
“Best Investors Insight 2: Don’t focus solely on returns.”
So many investors become consumed by high and fast returns, but find out too late they did not have a durable strategy. You will need to focus on a few more important factors in addition to return.
Read the 24 Best Investor Insights in my book, https://geni.us/InvestLiketheBest, or sign up for an “Investment Due Diligence” session to ensure you avoid this common problem and find out how to transform your experience. You will know in advance how this works and have real time access to metrics that tell you whether or not you are on track. Clarity and transparency will transform your confidence and results.
Nothing changes your wealth as much as your full cycle experience of a super bubble.
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