The Passive Investment Management (“Buy and Hold”) concept is older than any of us. It IS a sensible alternative to investors trying to time equity markets. Historically (over more than 100 years of data), Passive Investment Management beats most alternatives for investors. The additional costs incurred with active investing do create a drag on performance.
The Problems with Passive
There are two major problems with Passive Investment Management – at least in how it is presented to consumers today. The one we’ll explore today is that “historically” is a much longer period of time than most investors have.
Comparing your 10-20 year timeframe to 125 years of “historical” data is misleading. If you have less than 25 until retirement, your passive portfolio won’t serve you as well as “historical” suggests.
We have long held that investment managers tend to cherry pick their performance data to sway your investment management decision in their favor. We also believe investment managers generally expose clients to considerably more risk than is appropriate. Clients only realize that risk after it’s too late to avoid the damage. Investment management dogma is just that – Dogma. Be sure you pick an investment management style that is right for you.
There are many flavors of Passive Investment Management. In essence there are only a couple of rules that a Passive Strategy must follow.
- Once the portfolio mix is set, asset allocations should stay the same. Short-term performance or economic factors should not matter. The manager should never alter the asset allocation mix.
- Occasional (quarterly or annually) rebalancing is required to sell winners and buy losers. This rebalancing brings asset allocations back to the originally prescribed amounts.
Passive vs Active
Over 100+ years of data, passive investment strategies do better than most active counterparts. There are two reasons. The first is that Active Management costs (both transaction and management fees) are higher than passive costs. These costs tend to outweigh any excess gains enjoyed from implementing the active strategy.
The second reason? Most (though not all) Active Investment Strategies are Market Timing oriented, especially those executed by non-professional investors. Market Timing is the most common type of Active strategy. The manager tries to predict/guess where the peaks and troughs are going to be, then uses that prediction to buy and sell accordingly. Sadly, even (most) “professional” active investment managers are market timers.
Over long periods (25 years or more), we agree that Passive Investment Management can beat Active Investment Management, especially Market Timing.
Where Passive Fails
Over shorter periods (3-25 years), however, rules-based (not market timing) tactical active styles will do better. When stocks are at or near the peak of a market cycle (as they are now), the downside risk over the next few years is much greater than the upside potential. That risk is always there, but it’s hard to notice after years of nothing but rising prices.
Based on research by several firms, current U.S. stock market valuations suggest that equity investors will see net losses over the next 12 years. Those losses are baked into the cake of your current Passive Portfolio.
Passive Investment Management is only better if you can keep the money completely invested for at least 25 years. That means no distributions and no changes to your investment management style until 2045. If you’re over age 40 today, that just isn’t realistic.
Your Action Step
My suggestion is to have a professional run the analysis so you can really understand how much down side risk is built into your portfolio today. If you need that money for retirement in the next 25 years (or less), you should understand the risks you are taking. It wouldn’t hurt to also be open to the options at your disposal to manage those risks.
Please don’t let six or seven years of recent history leave you complacent or ignorant of your current reality. That could prove to be an extremely expensive mistake.