Thursday, July 18, 2013

The Case Against Passive Investing

I hear "Those who don't learn from history are doomed to repeat it," at least once a week, but it would be a gross mistake to think that this simply means examining incident A in history, see similarities to present day, and believe we are going to endure the same outcome.  This oversimplified extrapolation is particularly evident in the investment community where a perfect storm of envy, fear, and statistics conspire to put logic out of its misery.

First some definitions: long term stock investors in this post refer to proponents of passive indexing where a equity allocation percentage is based on their risk tolerance rather than speculation on future performance of shares.  Thus, if you are an active investor (I would call you a speculator), changing allocations based on new circumstances, this post does not really apply to you.  When I use the word investor, I am only speaking to those who don't care about bull and bear markets, but rather passively put a fixed percentage of their savings into stocks in perpetuity (until risk tolerances change).

Passive investing is attractive because pulling up the classic chart of the Dow Jones Industrial Average starting from back in the days shows a sometimes rocky but ultimately one way direction higher--the lesson being that if you kept putting money in, you will eventually be rich and any price drop in the past 200 years was ultimately a great buying point.  But you can't use this as a history lesson.  In other words, you can't say look how great stocks did for the past two centuries and use that for justification to buy a bunch of stocks for the next 200 years.  Forget the fact that past performance doesn't guarantee future returns, but this is just lazy scholarship.  You have to ask yourself why did stocks perform so well for the past 200 years.  Is there something innate about stocks that makes them go up over the long term or is it because the underlying companies were so damn successful?  For stocks to repeat such a performance, their underlying companies need to do so as well.

Thus if you passively invest, you are playing poker without looking at your hand and betting every time.  Essentially, you are not analyzing whether the overall socioeconomic environment is conducive to growth.  All you have done is put faith in our public institutions and status quo, that the upcoming mile will look like the last.

Now that I wrote this, I realized how similar it is to my last post, but I'm too lazy to combine it.