7 Reasons Passive Investing is Dead
Weekly Investment Update | By Brian Schreiner
The current investment environment, with its elevated levels of volatility and uncertainty, is motivating investors to think about whether or not their investment strategy is right for the market conditions.
As an active investment manager, we believe clients are best served with a proactive strategy and, now more than ever, a passive approach seems is woefully inadequate. I came up with 7 main reasons passive investing isn’t likely to work going forward.
REASON #1: Passive investing ignores the golden rule.
Passive investing ignores the golden rule of investing: “buy low, sell-high.” As an investor, your goal should be to buy undervalued assets and to sell them at a premium. Research shows that starting valuations are the primary driver of long-term returns.
A passive investment strategy, by definition, disregards valuation (price). The strategy is to buy-and-hold; stay fully invested at all times. The strategy is always the same, regardless of whether stocks are cheap or expensive relative to their earnings and historical valuation.
Passive portfolios blindly expose investors to overvalued markets, setting them up for potentially devastating losses during inevitable market downturns. This neglect of fundamental value means passive investors are essentially price takers, destined to accept whatever the market offers, irrespective of whether it represents a sound investment. Eventually, price converges with value. Ignoring valuations is unsustainable and potentially disastrous, for investors planning for retirement.
REASON #2: Passive investing disregards investors' true risk tolerance.
Passive investing hinges on the unrealistic expectation of unwavering investor fortitude during market turmoil – a notion decisively refuted by reality.
When bear markets take hold, losses are often too much for investors to tolerate. Even if buy-and-hold works in theory, it’s inherently too risky for most investors. Unless you can sleep well, as your stock portfolio drops by 40, 50 or 60 percent, passive investing isn’t for you.
This emotion-driven selling is a direct consequence of employing an investment strategy that is out-of-line with the investor’s true tolerance for loss. By neglecting the predictable psychological pressures that compel investors to stop the bleeding in a bear market, passive investing proves itself a failed strategy in the face of inevitable market cycles.
REASON #3: Traditional passive investing does not provide true diversification.
The narrow focus of traditional passive investing, primarily to domestic stocks and bonds, represents a glaring limitation in today's diverse investment landscape. By adhering strictly to these conventional asset classes, passive strategies inherently overlook a vast array of potentially lucrative opportunities including commodities, natural resources, infrastructure, emerging markets, private investments, precious metals and digital assets. Each of these asset classes provides a unique risk/return profile and potential for diversification benefits, uncorrelated returns, inflation hedges, and potentially higher growth areas.
Passive managers’ self-imposed boundaries prevent them from fully capitalizing on the expansive universe of alternative investments. Active managers, unconstrained by index limitations, possess the flexibility to explore these alternative avenues, potentially enhancing portfolio returns and managing risk more effectively.
REASON #4: Despite what they say, timing is everything.
Conventional wisdom says, “It’s not timing the market; it’s time in the market.” In theory, over certain timeframes, this mainstream view might hold true, but over the long run, everything goes to zero. The best investment in the world can become the worst if bought at the wrong price, and the worst investment can become the best if bought at the right price.
The difference between making a fortune and losing one is, above all, a matter of timing. Amazon (AMZN) has been one of the best performing stocks of our lifetime, but between 1999 and 2001, shareholders lost 90%.
While passive proponents preach patience through such downturns, they overlook the crushing psychological toll and massive opportunity cost of waiting years or decades, just to break even. True wealth creation isn't about simply enduring losses; it's about strategically avoiding them and actively positioning capital for growth, especially for investors in or near retirement.
REASON #5: Passive investors’ narrow focus on low cost forfeits active alpha.
Low cost is a clear and quantifiable benefit, but the cost of active management isn’t what it used to be. Have you looked at the expense ratios of ETFs in the alternative investment space lately? The cost of investing has come down dramatically over the years.
Focusing exclusively on costs can blind investors to the potentially far greater opportunity cost they incur. By solely tracking broad market indexes, investors forgo the possibility of achieving higher risk-adjusted returns that alternative assets and skilled active managers might deliver. An active investment strategy can seek to navigate market inefficiencies and identify undervalued assets with superior growth potential.
Most investors lack the time, resources, and expertise for such rigorous analysis and may benefit from the guidance of a professional active manager. While active management may come with slightly higher fees, the potential for enhanced returns, especially when considering risk management and downside protection during volatile periods, could significantly outweigh the initial cost savings of a purely passive approach over the long term.
REASON #6: Risk increases with time; it does not decrease.
Every major stock market in the world has declined by 70% or more at least once and have had multiple declines of 50% or more. The risk of loss does not decrease with time; it increases. Nobel Laureate Paul Samuelson said, “The longer you own stocks, the greater the risk of a devastating loss.” Common sense confirms this. Think about driving your car. Does the risk of having an accident increase or decrease with drive time?
Wall Street misleads investors when they suggest that active management is inherently more risky than passive investing. Active managers can reduce risk by limiting exposure or strategically shifting portfolio holdings. Using the car analogy, when you’re not driving, you can’t crash. During periods when stock prices are overvalued, it makes sense to actively shift allocations to less risky investments. For investors who value risk management, active management and diversification to uncorrelated asset classes offer benefits passive strategies can’t provide.
REASON #7: Market history is not a monolithic tale; it’s a nuanced chronicle.
“Stay the course,” is a seductive yet perilous mantra for passive investors. While proponents tout the long-term upward trajectory of markets, this perspective dangerously downplays the devastating impact of historical market crashes like 1929, the dot-com implosion of 1999, and the 2008 financial crisis.
For passive investors, these weren't mere historical anecdotes; they were periods of real devastation. Blindly adhering to an index during such collapses meant riding the market all the way down, with their advisors telling them “market history shows… over the course of time…” The years, sometimes even decades, required to recover from these events starkly contrast with the "long-term" often cited, inflicting significant financial and emotional damage.
To dismiss these historical precedents as irrelevant is to ignore the inherent cyclicality of markets and the very real risk that a passive portfolio, tethered to an index regardless of its altitude, can be decimated when the inevitable downturn arrives. α
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