Investor Acumen
US Economic Outlook
Author: James A. Kostogryz Portfolio Strategist
Passive Investing: The False Promise of Mediocrity
Summary
Historically, earnings recessions not been good lead indicators of signifi- cant stock market declines of 10% or more. Furthermore, S&P 500 EPS recessions and associated stock market declines seem to be mainly a func- tion of the business cycle.
Highlights
* The explicit goal of passive investing is to achieve mediocrity.* Most individuals that try implement passive investing fail to achieve even the mediocre results hyped up by its advocates.* The philosophy of passive investing, and the entire multi-billion-dollar industry that is based on it, sets individual investors up for failure. * This report provides an in-depth analysis of the main reasons why the passive investing paradigm leads to failure for most individuals.
In this report, I will explain why the philosophy of passive investing, and the entire multi-billion-dollar industry that based on it, sets individual investors up for failure.
Mediocrity is Not for Everybody
The ultimate goal of passive investing – it’s over-riding ideal — is to obtain mediocre results. The first major problem with passive investing is that, upon reflection, most people will find that this ideal is simply not compatible with their personality and/or their values.
By definition, the best-case scenario for a passive investor is to obtain the “average” return on stocks – whatever that average happens to be during the period that they invest. Indeed, the objective of the passive investment philosophy is to mimic the performance of a person with no investment knowledge or skill that — precisely due to their ignorance and incompetence — decides to buy every single stock in the market, without any regard for its fundamental value, and weigh each one according to size. In this manner, the ignorant and incompetent person – and the passive investors that wish to mimic their results – can be assured of achieving mediocrity, or the “average” return of all equities that trade in the market.
Another way to describe the ideal goal of passive investing is that it seeks to obtain the result which, on average, a pack of one thousand monkeys will achieve over time by throwing darts at a wall covered with lists of randomly selected stocks.
Of course, the promoters of passive investing don’t advertise that the goal of their system is to mimic the results of ignorant people or a pack of monkeys. But this is, in fact, the goal of passive investing.
The philosophy of passive investing advises you to join a kind of club – a non-exclusive club that does not require you to expend any effort, possess any knowledge or exercise any skill whatever. The main attraction of this club is that, as long as you follow the rules, you will never be made to feel alone or dumb, because you will be an indistinguishable member of a very large herd in which your own individual performance will be as good or as bad as the most brilliant and the most incompetent members of the herd.
Now, being a member of this passive investing club does not promise you that your returns will be good or that you will meet any of your financial goals; reaching specific goals or financial objectives play no part of the philosophy of this club. The results you obtain by joining this club will be either good or bad – according to this philosophy, nobody knows. When you are a member of this club, everything is completely out of your control and your performance will depend entirely on your luck; more specifically it will depend on what the market happens to do while you are a member. The only thing that is promised by this club is the “safety of the herd” – if you follow the rules you will do as good — or as bad — as the other members of the herd.
For some people, with certain types of personalities and values, the promise offered by the philosophy of passive investing will, indeed, be alluring. But for many people, the promise of passive investing – the promise of mediocrity – will not be compatible with their personalities or their values. For these people the philosophy of passive investing fails to meet their needs, and it sets them up for failure, even if they tried it, because they are unlikely to stick to the system in the long-run.
Many people — even if they could be guaranteed a mediocre result — prefer to accept the risks associated with trying to do better-than-average. For these people, passive investing will not be an appropriate option for them. To the contrary, the philosophy of passive investing hurts them by inhibiting them from doing the the sorts of things that they need to be doing to become successful.
For Most People, Passive Investing Will Produce Results That Are Worse Than Mediocre
The ideal outcome for a person that practices passive investing is to obtain mediocre results. Mediocrity is the ceiling for passive investors; it’s their best-case scenario. However, for those that are wondering whether passive investing might be appropriate for them, they should know that in practice, the actual results of people that practice passive investing will typically be substantially worse than their ideal of mediocrity.
For most people, passive investing simply does not end up producing the mediocre results that are advertised. Passive investing systems are a little like weight-loss systems. They will perform as advertised if you actually follow the system. If faithfully executed, popular weight-loss systems like Weight Watchers, Atkins, Jenny Craig, South Beach, Vegan, Keto, etc. will actually help people lose weight. Similarly, passive investing systems, when faithfully executed actually will produce mediocre results. However, the problem with weight loss systems and passive investing systems is that that real-life humans don’t actually faithfully implement these systems. For example, with weight loss systems, people will often eat foods that they shouldn’t more often than they should. With passive investing systems people often fail to do what the systems require — such as dollar-cost average every month, reinvest all the dividends, rebalance portfolios regularly, never sell their stocks, etc. The difficulty of achieving mediocrity through passive investing is not a theoretical problem, it is behavioral problem.
Dalbar, Inc. is an analytics consultancy firm that has for over twenty years published a report called “Quantitative Analysis of Investor Behavior (QAIB).” The report is based on analysis of a massive database, covering over 30 years of historical data, that tracks the behavior and performance of individuals that invest in mutual funds. For over twenty years Dalbar’s QAIB report has been documenting the fact that individual investors, on average, severely underperform relevant benchmarks – i.e. they obtain results that are considerably worse than mediocre.
One of the interesting findings of the QAIB is that individual investors, on average, after considering all fees and costs, generally obtain results that are much worse than much-maligned professional active mutual fund managers. This is a fact that runs counter to the promotional narrative emanating from the industries that promote passive investing and/or DIY investing and trading. How should we interpret this data?
Based on the barrage of propaganda coming from the passive investing industry you would expect that Dalbar’s data would show that it is individual investors that invest in actively managed funds that are responsible for the poor average performance of individual investors. Based on the propaganda from the passive investing industry, you would expect that individuals that invest in passively managed mutual funds should, over the long-term, obtain results that (after all fees and expenses are accounted for) are far superior to that of individuals that invest in actively managed funds. Well, as it turns out, this is actually not the case.
Dalbar’s extensive data analysis shows that that over long periods of time, investors that invested in actively managed funds actually outperformed investors that invested in passive funds — by a significant margin. And active mutual fund managers – the scapegoats and whipping boys of the passive investment industry – on average, significantly outperform both the passive and active groups of individual investors!
Based on over 30 years of data and over 20 years of observing investor behavior, in its 2017 report Dalbar concludes that individual investors “lack the patience and long-term vision to stay invested in any one fund for much more than four years”.
Dalbar’s analyses, represent a major empirical rebuke of the passive investing philosophy. Two obvious questions are raised: 1) Why do passive investors fail to achieve even mediocre results? 2) Why does the average passive investor tend to do even worse than the average active investor? Many factors are at play, but I will highlight three main factors. The first two reasons relate to the financial effects of passive investing on investors that practice it; the third reason is behavioral/psychological in nature. All of these reasons show why passive investing, by its very nature, tends to set people up for failure.
The first problem is that passive investors, quite naturally, tend to fall into a pattern of blindly and apathetically investing virtually all of their cash savings every month. Indeed, automated dollar cost averaging plans tend to ensure that investors will lapse into this sort of complacency. Passive investors, that are lulled by this philosophy into an attitude of complacency, and therefore fail to be active about managing their financial affairs, are naturally relatively more prone to run into liquidity problems. Such investors are more likely to get caught in situations where, due to illiquidity (due to any number of reasons, such as higher-than-expected expenses) they will be forced, to sell their investments at inopportune times.
The second problem of a financial nature that sets up passive investors for failure is that the passive investment philosophy encourages individuals to be fully invested at all times. There are two problems with this. The first problem is that passive investors will tend to be financially “over-exposed,” relative to their own emotional tolerance, when there is a major decline in financial asset prices and/or when there is otherwise unsettling news. This over-exposure renders passive investors more likely to sell assets at exactly the wrong time – i.e. when they should actually be buying. Secondly, by being fully invested at all times, passive investors will not have cash to buy securities when it is most advantageous to do so – i.e. when they have fallen severely in price.
In other words, the passive investing philosophy sets investors up an asymmetric set of possible outcomes which, on average guarantees less-than-mediocre results. Please note the asymmetry of outcomes: When a passive investor is fully invested, there is zero chances of obtaining any benefit from this situation. However, there is a significant probability that a passive investor that is fully invested during a market downturn will, in practice, panic and sell at exactly the wrong time. Passive investing sets up an asymmetric set of possible outcomes where an individual investor has absolutely no chance of doing any better than mediocre, while there is a significant probability that the investor will sell at exactly the wrong time.
Now, compare the asymmetrical situation faced by passive investors with the situation that active investors will experience. For purposes of this comparison – just for one moment – let us assume that active investors are no more likely nor less likely to sell their securities in the midst of a major downturn than passive investors. In other words, let us assume that both active investors and passive investors are subject to the same types of financial and behavioral influences and that they respond to them similarly and that in a sample of active and passive investors, there will be a similar percentage of “panic sellers”. The difference between the active group of investors and the passive group of investors is that some of the active investors will actually have some cash available to invest in the midst of the market downturn and some of them will actually invest that cash – precisely at the most advantageous moment. As long as some active investors actually employ their cash to buy securities during a downturn, and that there are similar percentages of panic sellers among active and passive investors, active investors will necessarily outperform passive investors.
But advocates of passive investing will object: “Passive investors are less likely than active investors to engage in passive selling!” Really? In all of the academic and promotional industry literature which promotes passive investing I have not seen a single empirical study which has claimed that passive investors are better at resisting the temptation to engage in “panic selling” during a major downturn.
So, is there any evidence on this matter? Well, it turns out that there is. Dalbar’s 2017 study on Active versus Passive investing revealed that individuals that invested in actively managed funds actually had higher retention rates – i.e. sold their holdings less often. Dalbar cited this factor as a key reason why why, over long periods of time, individuals that invested in actively managed funds outperformed investors that invested in passively managed funds. This bears repeating: Dalbar’s study concluded that over long periods of time, individuals that invested in actively managed funds tended to outperform individuals that invested in passively managed funds.
In practice, active investors tend to outperform passive investors for two reasons: First, some active investors have cash to invest in a downturn which fully invested passive investors do not. Second, many active investors — by virtue of being proactive – tend to be more psychologically prepared than passive investors to avoid the mistake of selling securities in the midst of a major market downturn. In sum, passive investing sets individuals up to fail, both in terms of their relative financial exposure, liquidity conditions and psychological disposition.
Mediocrity is not Enough
Individuals that are really great at passive investing – the very best passive investors — will obtain absolute results that are no better than the average return for securities in the market during the period in which they invest. Therefore, if you are really good at it, passive investing has the potential to protect your ego against failure. However, it is crucial to understand that passive investing is not designed to enable investors to obtain any kind of financial success. Passive investing – in a best-case scenario – only promises mediocre results in terms of relative performance. Achieving goals in terms of absolute performance is completely beyond the scope of what passive investing claims to do.
The problem is that, during some long stretches of time – average returns are quite low and will be insufficient to meet many people’s needs. Furthermore, for a great many people, even obtaining the average return during average times will be insufficient to achieve their goals. Thus, the third and final reason why passive investing sets many people up for failure is that the mediocre results that passive investing promises – but rarely actually delivers – will simply not be sufficient for many people to achieve their financial goals.
An analysis of 10-year rolling returns shows that for more than 30% of the time, average real returns on the S&P 500 index (with dividends reinvested and paying no taxes) are less than 3.0% per annum. In other words, 30% of the time, “mediocre” 10-year returns are flat-out bad – certainly not enough to meet most people’s goals. In other words, about 30% of the time, people that have invested in stocks have only obtained a 3.0% return after waiting for 10 years – assuming they paid no taxes and they religiously reinvested all of their dividends.
Furthermore, on average, the 10-year real annualized return on the S&P 500 has historically been about 7% — again, assuming no taxes and reinvestment of dividends. This “average” 10-year annualized return that investors have historically obtained on average – even if this sort of average return could be guaranteed in the future — will simply not be not enough for many people.
There is a further problem. It is highly unlikely that given the current state of the US business cycle and the current level of valuations, that passive investors will obtain average annualized real returns of 7.0% going forward. Real annualized average returns going forward are likely to be lower than the historical average. The first reason for this is that 10-20 year returns on equity investments made in the Late Expansion stage of the business cycle tend to be very low. The second reason is that valuations are currently above historical averages, and this strongly suggests that future 10-20 year returns will be lower than average. Finally, historical returns have been benefited greatly by a long-term secular increase in PE ratios. Going forward, stock returns are highly unlikely to get this sort of boost from ever-expanding PE ratios. Without PE expansion, historical real returns would have been more like 5.0% rather than 7.0%. And with PE ratios more likely to shrink going forward than to expand – given the current state of the US business cycle and the current level of valuations – real average annualized returns on US equities starting from now are likely to be in the low single digits for the next 10-20 year period.
Overall, taking into account the fact that the US business cycle is in its Late Expansion stage, the fact that valuations are above historical averages and the fact that average long-term PE ratios are unlikely to continue to expand, most passive index fund investors will be lucky if they can get 3.0% real long-term returns on their investments going forward. In other words, 3.0% per annum is probably the “best case scenario” for index investors going forward – assuming they don’t actually make the mistakes that putatively “passive” investors are prone to making. For most investors, this sort of outcome is simply not enough. But by embracing passive investing, they are setting themselves up for this failure.
Conclusion
The goal of passive investing is to obtain mediocre returns. There are several problems with this. First, for many people, the pursuit of mediocre returns will not be compatible with their personalities or values. Second, with passive investing, mediocre returns represent a ceiling – a ceiling that most passive investors will not even achieve. In fact, on average, passive investors will do significantly worse than mediocre. Finally, the best-case scenario for passive investors in terms of long-term returns will probably not be sufficient to meet the financial goals of many individuals.
For those individuals whose personality and values will not allow them to set mediocrity as their goal; for those individuals that want to set excellence as their ceiling; for those individuals that actually require better-than-average returns to meet their financial goals – for these individuals, passive investing is simply not for them. These individuals need the knowledge, the skills, and the tools that enable them to succeed.
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This is an interesting take James. I can tell you if I was your average Joe, and didn’t have an active interest in investing or any desire to learn economics or portfolio theory, I would most likely take a passive approach to investing.
Here’s why: There’s been a lot of scrutinizing over the performance of investment professionals recently. Clients are becoming more aware of the cumulative destructive nature of hidden fees coupled with just how often a lot (if not the majority) of advisors are failing to contribute any significant value over the index net of fees.
You had the oracle of omaha challenging and winning a bet that stipulated that The S&P 500 Stock Index Would Outperform Hedge Funds in 10 year timeframe and it did by a large margin. What does this do to increase the confidence that the money managers are the very top of the investment game–you know, the guys that are so good, you say sure to 20% performance fees–Result zero confidence.
I recently read Tony Robbins Unshakeable, and the thesis was the same. Countless examples of the idea, that as soon as the average advisor decides to make an investment choice of their own, your net returns decrease.
Now, I know that personally I want to try to beat the benchmark; and i’m uniquely positioned to do this. But if the research is showing the majority of fund managers and stock brokers can even’t beat “Mediocre”, then perhaps mediocre is the smart choice for everyone else who isn’t going to learn the market’s punitive rules.
Just my two cents.
Adil::
Excellent analysis. You are correct that my article is directed towards those that want to do better than mediocre and are willing to do what is necessary to achieve it.
Thanks for your comment!
James