Passive Investing Is Dangerous

Passive Investing Is Dangerous Because It Is So Easily Confused With Indexing.

I am a big believer in indexing. Indexing is buying shares of all stocks in a particular market so that your performance matches that of the overall market. Most investors are not able to spend the time needed to pick stocks effectively, so indexing makes a great deal of sense for a great number of people. I developed the Valuation-Informed Indexing approach to provide people a realistic means of taking advantage of the indexing strategy.

Passive Investing

I do not recommend passive investing. Passive investing is dangerous. I urge middle-class investors seeking financial freedom early in life to at all costs avoid passive investing. Passive investing can wipe out years of your savings. Don’t go there.

The biggest danger of passive investing is that it is so easily confused with indexing. Many investors view the two terms as synonymous. Indeed, many investing “experts” view the two terms as synonymous. I do not view the terms as synonymous. I view indexing as a good choice for intelligent investors. I view passive investing as a trap for the unwary.

Passive Investing Is Dangerous Because it is an Emotionally Immature Approach.

Indexing is an investing approach for those who have achieved a high level of emotional maturity. We all start out thinking that perhaps we will become the next Warren Buffett. Most of us are disabused of that notion after experiencing the financial losses often suffered by those guilty of such hubris. Indexers are investors who have overcome the need to brag at parties about their great stock-picking ability. They invest for less egocentric reasons — to provide for their loved ones, to overcome paycheck dependence, to finance their retirements. Indexing is emotionally smart.

Passive investing is not. Passive investors decide on a stock allocation, put it in an index fund, and then never adjust it in response to changes in stock prices. That’s not emotionally smart, that’s emotionally dumb. That’s a form of hubris greater than the hubris exhibited by those who believe that they can become the next Warren Buffett. Those thinking they can become the next Buffett can at least point to one guy who pulled it off — Buffett! I don’t know of anyone who has been able to ignore stock prices and not pay a price for doing so when the wild bull market that gave rise to the hubris became the wild bear market that inevitably follows.

The desire to index comes from a healthy place. Acknowledging that you are not likely to be able to outsmart the market is an act of humility. The desire to invest passively comes from a sick place. Thinking that stocks will perform during your lifetime in ways in which they never have before is an act of arrogance.

There is nothing to the indexing approach that requires that one engage in passive investing. Emotionally healthy indexing is active investing, whether achieved through picking stocks (which of course can be combined with indexing) or buying shares in indexes and adjusting one’s stock allocation in response to big price changes.

Passive Investing Is Dangerous Because it is an Irrational Approach.

Advocates of passive investing herald it as the most rational approach. I strongly disagree. Passive investors are not rational. They are rationalizing.

The idea that not responding to changes in prices is rational is an outgrowth of the Efficient Market Theory (I often refer to it as the Efficient Market Disease). I can see why those who believe in the idea that the market price is at all times in some mystical sense “right” believe that passive investing is best. If the market price is always equally appealing, why invest actively? There is a certain strange logic being followed by those who stick to the same stock allocation despite swings in stock prices from undervalued to fairly valued to overvalued.

The question is — Is the Efficient Market Theory rational? If the Efficient Market Theory is irrational and if investing passively is an idea that depends on the Efficient Market Theory for its logical support, then investing passively too is irrational. I have devoted years of mental effort to the task of trying to make sense out of the Efficient Market Disease (er, Theory) and have not been able to make even a tiny bit of sense out of it. If you prove more successful in this pursuit, you might want to give the idea of investing passively serious consideration. If not, I suggest that you dismiss it as an irrational approach.

investing passively

My view is that it is an emotional desire to Get Rich Quick that is the source of the appeal of passive investing. People know that when stock prices get out of hand the long-term value proposition of owning stocks drops, but they turn to theories like the Efficient Market Disease (it has gone by other names in other wild bull markets) for a time to block out consciousness of what they know.

Passive investors frequently cite “studies” and “theories” and “logic” in support of their investing choices. However, the drive behind exploration of these sorts of studies and theories and logic appears to be the emotional quest for the perpetual motion machine, for the fountain of youth, for the stock market that can go up and then not need to come back down. This is a non-reasoning sort of “logic.”

Passive Investing Is Dangerous Because it Makes Reasoning Impossible.

We all make mistakes. It’s part of life. When we discover them, we fix them. Passive investors can do the same, no?

No. Often they cannot bring themselves to do so. Persuading oneself that passive investing is a good idea is a difficult business. We all understand that prices matter when buying houses or cars or bananas. How is it that some of us are able to turn off our minds to the extent necessary to come to believe that prices might not matter when it comes to buying stocks?

It ain’t easy, that’s for sure. What passive investors do is to adopt a mindset which argues that possessing knowledge about investing is a bad thing. Passive investors don’t just conclude that market returns are good enough for those who don’t want to put in the effort required to pick stocks effectively; they argue that picking stocks effectively is impossible! They argue that Warren Buffett and the millions who have successfully followed strategies similar to those he follows are just lucky!

I’m not kidding.

I have seen numerous cases in which “experts” who advocate passive investing have made this claim. I have participated on discussion boards at which followers of such “experts” have said that their own strategies are rooted in a belief in such claims. I have heard such people refer to themselves as “Know-Nothing Investors.” They are proud of their unwillingness to apply their intelligence to the investing project. They see willful ignorance as a virtue when making investing decisions (but only then, I presume).

Not this boy. Find someone else. No can do. I can’t go for that.

Any investing approach that requires that you embrace ignorance of how investing works as a first step is terribly flawed, in my estimation. The big problem is that, once you declare yourself a Know-Nothing Investor, there is no hope of your ever learning from your mistakes. Passive investing worked well during the huge bull. It has not worked at all well since the wild bull came to an end in early 2000. But many passive investors maintain that the thing to do today (this article was posted in January 2008) is just to stick to the strategy.

What if stock prices fall still farther? The logic of the passive investing approach says that no change is justified even in these circumstances. Passive investors have no means of determining that they have made a mistake because their strategy is rooted in a rejection of the idea that intelligence can be applied to the investing project in an effective way. Not good.

Passive Investing Is Dangerous Because It Encourages Defensiveness.

Things often do not go the way we want in life. Often the best that we can tell ourselves in the face of things we do that hurt ourselves or others is: “Well, I tried my best.” Passive investors cannot do this. The best that they can say is: “I tried nothing.” It’s not the same.

The Great Safe Withdrawal Rate Debate has been a remarkable series of discussions. We have shown beyond any reasonable doubt whatsoever that the Old School safe withdrawal rate studies get a number that people use to plan their retirements wildly wrong (please see the “Risk Evaluator” section of the site for background). Yet the authors of the studies have not corrected them. “Experts” who have been asked to help get the word out to the retirees who constructed their plans pursuant to the demonstrably false claims of the Old School studies have been reluctant to help out. What’s all that about?

modern portfolio theory I can’t see into people’s minds and hearts. The best I can do is to offer my personal take on this. My take is that the authors of the studies and the experts we have contacted feel a good amount of guilt over the damage that they have done to retirees by their earlier support for the now discredited studies. It is not a small number of people who have suffered financial losses or taken on excessive risk as a result of these studies; the number is in the millions. And the analytical errors in the studies seem like painfully obvious ones once they are brought to people’s attention. “We forgot to account for the effect of valuation changes on long-term returns? Oops! Duh! Like, yeah, I guess we need to fix that! Duh-Duh!”

We need to fix that. But the first step to fixing it is acknowledging the harm done by our failure to note the error in the first place. For those who have come to think of themselves as “study authors” or “investing experts,” it’s not so easy a thing to do. Passive investing is willful blindness, for the reasons explained above. Willful blindness hurts humans and other smart, fun-loving mammals.

My sense is that many are attracted to passive investing because it at first appears to be such a no-muss, no-fuss approach to investing. They do so without making a sober assessment of the harm that this approach can cause down the line. After a good bit of harm has been done, it becomes difficult for these people to acknowledge that they were responsible for it; they seek refuge from taking responsibility for their mistakes in excuses and word games.

It is not an accident that passive investing has led to such irresponsibility. Adoption of a passive investing approach is a deliberate choice to ignore the most important and most basic lesson of stock-market history (that what goes up must someday come back down). The level of defensiveness that we have seen in the first six years of our discussions has been shocking and appalling; I certainly do not mean to excuse it. However, I don’t think that the fact that we have seen defensiveness should come as a total surprise; it is an inevitable consequence of widespread adoption of a fundamentally irresponsible strategy.

Passive Investing Is Dangerous Because It Makes Buy-and-Hold Strategies Unworkable.

Most passive investors say that they intend to practice buy-and-hold investing. That is, they plan is to avoid selling stocks when prices drop, the mistake that has caused middle-class investors of the past to view stocks as the riskiest of investment classes. A review of the historical stock-return data offers little grounds on which to place confidence in these claims.

The investors making these claims are right to argue the merits of a buy-and-hold strategy. Their mistake is in thinking that buy-and-hold is a realistic strategy for investors who are wildly overinvested in stocks. Investors who followed a passive approach as stock prices climbed to the la-la land levels where they reside today are by definition overinvested in stocks. The historical data shows that stocks become far, far more risky at high valuation levels. Investors who set their stock allocations at times of reasonable prices and then declined to make adjustments when prices rose to absurd levels have allowed reasonable allocations to become wildly dangerous ones.

Buy-and-hold investing makes a great deal of sense when employed by investors who make reasonable adjustments to their stock allocations at times of high prices. It does not make sense for those who fail to do so. Buy-and-hold and passive investing, like drinking and driving, do not mix.

Passive Investing Is Dangerous Because It Requires a Grim Determination to Suffer Bone-Crushing Losses.

Most passive investors possess little understanding of what sorts of losses they have set themselves up for by buying into the passive investing idea. There have been three times in the history of the U.S. market when stock prices have been in the same general neighborhood that they are in today. The average price loss for those three occasions was 67 percent. That number does not reflect the effect of dividends earned while prices were falling. When the dividends factor is incorporated into the analysis, the size of the expected real loss drops to only 40 percent.

investment theory Even a 40 percent loss in real portfolio value is a big deal to many of today’s middle-class investors. Many of today’s investors have been invested in stocks only at some point from the early 1980s forward. They have experienced a wild bull market personally. They know of what happens in the wild bear markets that inevitably follow wild bull markets only from reports in history books, which make a far less compelling impression.

I don’t believe that anyone should put a dollar into stocks without first learning about how much changes in price levels affect the long-term returns earned by investing in this asset class. The reality, of course, is that many do. The passive investing strategy exacerbates the negative consequences that follow from this unfortunate reality.

My guess is that many investors who are not believers in passive investing will get out of stocks when prices drop hard; they will suffer losses, but in many cases the losses will not be large enough to ruin them. Passive investors often vow to stick with their oversized stock allocations no matter what. That is truly a recipe for disaster. Those who sell at the bottom suffer the most from a bear (and those highly overinvested in stocks and vowing never to sell are obviously taking a big risk of being forced to sell near the bottom).

Stocks are not nearly as risky an asset class as they are made out to be. We make stocks dangerous with our unwillingness to acknowledge the lessons of history. Investors who elect to ignore the effect of valuations on long-term returns make stocks a far more risky investing class than they were meant to be.

Passive Investing Is Dangerous Because It Discredits Indexing.

Indexing will be blamed when passive investing causes middle-class investors to suffer huge losses. But it won’t have been indexing’s fault. There is nothing in the nature of indexing that requires those employing it to ignore valuations.

I believe that the public’s faith in indexing will be restored in time. But I also believe that it is unfortunate that indexing has become associated in the public mind with passive investing. I would like to see responsible advocates of indexing do more to point out that there is no necessary connection between the two ideas.

Passive Investing Is Dangerous Because It Encourages Consideration of Other Dubious Investing Beliefs.

All investing involves risk. It is the nature of the beast. Investing passively increases the risk dramatically and in a way that serves no possible constructive purpose (the drive behind passive investing seems to be rooted in the most negative of investing emotions — a raging greed or an unconquerable fear). “Solve” the struggle with risk that way (passive investors address risk by ignoring it and thereby making it many times more potent a problem), and you encourage the adoption of all sorts of dubious ideas about what works in investing.

Eugene Fama

Review the comments of indexers posted in the “Investing Discussion Boards Ban Honest Posting on Valuations!” article (please see the “Banned at Motley Fool!” section of the site) and you will see numerous observations of the rabid dogmatism of those following the Lindauerhead approach to indexing. Is there something about indexing that requires dogmatism? Obviously not. If all indexers were as extreme as the Lindauerheads, we wouldn’t have seen so many participants at The Old Vanguard Diehards Board objecting to it.

My sense is that it is a rigid adherence to the tenets of passive indexing that brings on unhealthy levels of dogmatism. Most indexers are reasonable. Those who try to defend the passive investing idea in reasoned discourse find it so difficult to make a rational case that they turn to dogmatism and defensiveness to block out questioning. It is but a small step to claims that indexing is for everyone, even those quite able to pick stocks effectively.

Dogmatism begets dogmatism. Defensiveness begets defensiveness. I refer to the Efficient Market Theory as a disease because I have seen on a number of discussion boards how it can turn otherwise smart and good people into frothing-at-the-mouth attack dogs. There’s something deeply wrong with an investing strategy that has a long history of turning humans into monsters. There’s something not right about that theory and about the investing approach that is its bad-seed child.

Passive Investing Is Dangerous Because It Plays Games With Your Mind.

A number of Lindauerheads have described their investing history prior to their discovery of passive investing as a testing of various Get-Rich-Quick approaches that ultimately did not pay off. I believe that passive investing is for these people just one more in a long list of brilliant mistakes.

The most convincing salesman is the fellow who persuades you that he is not trying to sell you something. That’s passive investing. The pitch made for it causes us to let down our guard because it all sounds so — well, passive. It hardly even sounds like those making a pitch for passive investing are trying to sell us something.

But they are. They are trying to sell us on the idea that it all is going to turn out different this time. Check out The Investor’s Scenario Surfer (see tab at left). It is rare to turn up a scenario in which passive investing (rebalancing is a passive strategy) provides better results than valuation-informed investing. So why have so many bought into the promise that passive investing might work out this time?

Index Mutual Funds It sure sounds good at the top of a bull. On the one hand, those following passive strategies are told that they are smarter than all their friends. On the other, they are told that they don’t need to know anything or to learn anything to become so gosh-darn smart. A great wave of intelligence passes over those smart enough to listen to the pitch and not raise any difficult questions.

Passive investing sounds too good to be true.

I wonder why.