Rational Investing vs. Passive Investing

Rational Investing vs. Passive Investing, Comparison #1 — Definition

A regression analysis of the historical stock-return data shows that the most likely 10-year annualized real return for U.S. stocks beginning at the valuation level that applied in 1982 was 17 percent.

Rational Investing

A regression analysis of the historical stock-return data shows that the most likely 10-year annualized real return for U.S. stocks beginning at the valuation level that applied in 2000 was a negative 1 percent.

There is no one stock allocation level that makes sense both at times when the most likely 10-year return is 17 percent and when the most likely 10-year return is a negative 1 percent.

Passive Investing is an approach to investing in which investors stick to a single stock allocation despite dramatic changes in the likely long-term return for stocks. Given that it is impossible for the rational human mind to imagine a logical case that can be put forward in support of this approach, the appeal of Passive Investing must be emotional (it has always been the case that stocks possessed the greatest emotional appeal at times when they offered the weakest long-term value proposition).

Rational Investing is the approach to investing used by those seeking to avoid the influence of the most negative investing emotions and thereby to maximize long-term returns. It is the approach used by those who resist the lure of the Passive Investing concept.

There are many varieties of Rational Investing. Even investors with a vague desire to following Passive Investing principles often incorporate many rational elements into their investing plans.

A desire to invest rationally comes naturally. Passive Investing becomes popular only when stock prices have risen enough to stretch investors’ abilities to maintain control of their most negative emotional impulses to their limits.

Rational Investing vs. Passive Investing, Comparison #2 — Starting Point

You determine at a time when stocks are selling at fair value (a P/E10 value of 14) that the right stock allocation for someone in your circumstances is 60 percent. Over the next five years, the P/E10 value climbs to 20. Do you lower your stock allocation? Or do you let things ride?

This may be the most important decision you will ever face as an investor. Choose to let things ride and you have allowed your unfortunate human attraction to Get Rich Quick schemes to overrule your judgment. Once you do that, it becomes harder and harder to choose the Rational Investing path as times goes on.

But consider what you will be up against. During a time-period when the P/E10 value is rising from 14 to 20, returns are a good bit higher than the 6.5 percent annualized real return that is the norm for the U.S. market. You’ve been enjoying these super returns for five years. And you’re going to lower your stock allocation, give up all this wonderful Money for Nothing just because it’s the rational thing to do? What?! Are you crazy?!

Science of Investing The emotional case is all in favor of Passive Investing.

What’s the case for Rational Investing? That Get Rich Quick schemes never pay off long-term. That the risk of a big price drop is now so high that the potential gains from staying at the same stock allocation don’t justify the potential costs. That the historical data shows that lowering one’s stock allocation in such circumstances has always been the better choice.

I know — that’s all so much blah, blah, blah, blee, blee, blee for so long as prices are rising to ever more unsustainable levels. Emotions are always going to have an influence when it comes time for investors to make stock-allocation decisions and that’s of course particularly so at times of dangerously high prices. Still, I think we need to acknowledge for the record that the Rational Investor would take it the other way. We don’t aim to go on longer trips when gas prices are rising, do we? We don’t aim to stock up on corn flakes when there’s a corn shortage and the price has doubled. Stocks are the only thing we buy for which we pray for rip-off prices to come into effect.

Rational Investing vs. Passive Investing, Comparison #3 — Gaining Experience

The discouraging news is that Rational Investing is hard to choose. The encouraging news is that it is relatively easy to stick with once you choose it.

We all know that the excess returns paid to stock investors during wild bulls isn’t printed up by Milton Bradley. We all have concerns on some level of consciousness that the party is going to come an end and that we are going to get stuck holding the bill. Worrying doesn’t help. Talking about our worries doesn’t help. What helps is doing something constructive — lowering our stock allocations.

You may not see an immediate reward for electing to invest rationally and to lower your stock allocation in response to price increases. Even if you don’t see an immediate financial gain, however, you will feel better about yourself knowing that you have permitted reason to gain the upper hand over your most destructive Get-Rich-Quick emotions. You might doubt yourself from time to time. Probably less often than you might now imagine, however.

For the Passive Investor, things go downhill regardless of whether he sees a short-term financial payoff for investing emotionally or not. If stock prices go down hard, the Passive Investor panics because of the price drop. If stock prices go up, the Passive Investor grows more intensely emotional because he is not able to feel comfort in his irrational decisions. Passive Investing doesn’t work because investors need to be able to stick with a plan for the long-term for it to work and Passive Investors can never possess the level of confidence in their decisions needed to stick with them for the long term.

Rational Investing vs. Passive Investing, Comparison #4 — Learning

Rational Investors are learning investors. One of the scary things about investing is that it is impossible to know all that you need to know when you start. Much of what you learn you must learn from experience. Things obviously should get better over time. For Rational Investors, they do.

How to Invest It’s not so for Passive Investors. Passive Investing is a dogmatic approach. That’s so by definition. The very appeal of Passive Investing is that it is a non-thinking approach; it’s not possible to effectively question an emotion, so Passive Investors see their choices as being beyond question. The emotional appeal of the Get Rich Quick scheme causes investors to want to try Passive Investing, and their desire for rationalizations to support their decision creates a market for “experts” to come up with some. But none of the rationalizations can stand up to logical scrutiny.

The result is that the Passive Investor dares not become more knowledgeable as time goes on. The most fundamental investing issue is the determination of one’s stock allocation. The Passive Investor’s mind is closed on this topic on the first day. And the process of choosing a stock allocation is so fundamental to the success of the investing project that the Passive Investor cannot open his mind to new ideas without putting his entire belief system into doubt. How can a learning experience take place in such circumstances?

A non-thinking approach can under stress easily be transformed into an anti-thinking approach. Passive Investors start out behind Rational Investors and then fall farther and farther behind as time goes on.

Rational Investing vs. Passive Investing, Comparison #5 — Strategy

Rational Investors have all sorts of strategy questions to consider. Is it best to stick with indexing or should the investor move to picking individual securities as she becomes more knowledgeable? How important is it to shift from a focus on U.S. stocks to global investing? How is successful investing different for those in the distribution stage (retirement) of the investing life cycle from those in the accumulation stage of the investing life cycle? Is it only those near retirement who need to be concerned about big losses or should avoiding big losses be a big consideration even for young investors?

None of these questions make any sense for the investor who has chosen the 100 percent emotional path. There are few strategic problems that can be addressed by those unwilling to make adjustments in their stock portfolios. Passive Investors give away all of their most important tools for making sense of the investing project prior to putting forward any serious effort to figure it out.

Rational Investing vs. Passive Investing, Comparison #6 — Risk

Rational Investors understand both the good and bad side to risk. They are willing to take on risk, but insist on being compensated with higher returns for doing so. Thus, they seek out investment classes that provide a high return to investors taking on moderate levels of risk while disdaining asset classes that require investors to take on extreme levels of risk in exchange for little in the way of potential gains.

How Investing Works

Passive Investors are extremely uncomfortable with informed discussions of risk. For Passive Investors, risk decisions are properly emotional decisions. They see great appeal in high-risk/low-return asset classes; it is during times of high stock prices that Passive Investing inevitably becomes extremely popular for a time. They have contempt for asset classes that offer great returns at minimal risk. At the height of popularity of the Passive Investing approach, Treasury Inflation Protected Securities (TIPS), a risk-free asset class, were paying a guaranteed return five full percentage points higher than the most likely 10-year return for stocks. Passive Investors dismissed anyone seeing merit in TIPS at the time as mentally disturbed.

The risks that alarm Passive Investors are risks to their fragile “understanding” of how stock investing works in the real world. Passive Investors seek to avoid consideration of the realities of risk under the thinking that risks that they are not informed about cannot hurt them. The historical stock-return data offers zero support for this “theory.”

Rational Investing vs. Passive Investing, Comparison #7 — Conflict

Conflict between Rational Investors and Passive Investors is inevitable if they attempt to engage in discussions of their respective approaches.

The root problem is that the two groups of investors are proceeding from entirely different premises. Rational investors are seeking to maximize the return on their investments. The election to pursue Passive Investing is an election not to seek to maximize returns. The very idea behind the Passive Investing approach is to keep at bay facts and data that would cause emotional anguish for those pursuing fantasy approaches.

The first inclination of Rational Investors is to look for reasons for various possible options. The first inclination of Passive Investors is to respond to the discussion of reasons with anger. Reason and emotion speak different languages and so it is all but impossible for investors in the different camps to communicate with each other.

The reality, of course, is that many investors who identify themselves as Passive Investors in fact feel little commitment to the approach. Passive Investing is an idea that becomes popular in runaway bull markets, which always attract many people with little interest in stocks to participation in the market. A good number of these will describe themselves as “Passive Investors” so long as that remains a popular sort of investing, but will abandon this “philosophy” when its downside becomes obvious. Some of these investors will abandon stock investing altogether as a result of their bad experience. Others will open themselves to consideration of more effective approaches and in time will become highly rational investors.

Keeping Your Sanity re Investing Only the most dogmatic of Passive Investors are truly beyond the reach of human reason. Unfortunately, it is the purists who possess the most influential voices in the Passive Investing camp.

Rational Investing vs. Passive Investing, Comparison #8 — Buy-and-Hold

Passive Investors often claim to be long-term buy-and-hold investors. It seems highly unlikely, however, that many Passive Investors will be able to stick to buy-and-hold once it is put to its first significant real-world test.

Passive Investing is blind investing. Since Passive Investors don’t change their stock allocations in response to price changes, most don’t bother to learn much about the effect of valuations on long-term returns. In many cases, such learning would bring on feelings of discomfort. So Passive Investors are not able to make much sense of why stock prices sometimes go up for long periods of time and at other times go down for long periods of time.

That ignorance makes the practice of an effective buy-and-hold strategy all but impossible in the real world.

Buy-and-hold is of course effortless during a wild bull or in the early years of the secular bear that follows, when there are still widespread thoughts that the bull is coming back. It is when the bear has been in place for some time that buy-and-hold strategies are tested. It is the Rational Investors who are best positioned to survive the test. A Rational Investor understands why prices are coming down and has lowered his stock allocation to prepare for the price drop. A Passive Investor is mystified as to why stocks are no longer performing as they are “supposed” to.

Rational Investing vs. Passive Investing, Comparison #9 — Emotion

Reason begets reason. Emotion begets emotion.

Rational Investing vs. Buy-and-Hold Passive Investing is rooted in emotion. The investing experience of the Passive Investor becomes more emotional over time as the real world shows an increasing unwillingness to conform to the dictates of the Passive Investing mindset. The real world can be so contrary; I sometimes get the feeling that it just does not care too much what all those Ivory Tower Eggheads say in their papers and studies and books and speeches! The world is not passive. The market is not passive. Reason is not passive. It is only the Passive Investors who are passive. As awareness of the disconnect dawns, we see dismay and shock and defensiveness and anger.

Rational Investors fall prey to negative investing emotions too, of course. The difference is that investors who struggle to overcome their negative emotions become increasingly confident over time in their ability to do so.

I got out of stocks in 1996. In 1997, 1998, and 1999, stock prices shot up dramatically. I had a few moments of weakness when I had to review the historical data to confirm that what I had seen on earlier surveys really was there. I rarely experience these sorts of doubts today. I have been following the Rational Investing approach (changing one’s stock allocation in response to dramatic price changes) for long enough now (this article was posted in April 2008) and have seen it tested in a sufficient number of different environments that my confidence in it is much stronger. I don’t say that I will never again experience doubts. I believe that I will. I also believe, though, that my greater confidence is here to stay. I will have a greater ability to cope with those doubts because of what I have learned by following the Rational Investing course for over 10 years now.

Passive Investing starts out bad and gets worse. Rational Investing starts out good and gets better.

Rational Investing vs. Passive Investing, Comparison #10 — Other Investing Approaches

There are many rational investing approaches. There are things that we can learn from investors using fundamental analysis, and from investors using technical analysis, and from investors following momentum strategies, and from investors following contrarian strategies, and so on. Rational Investors are open to all these learning experiences. Whatever helps us earn enhanced returns is seen as a good.

Rational Investing Is Emotional Healthy Investing

It’s not so with Passive Investors. Because Passive Investing is an artificial construct (there is no possible rationale for investing passively — the entire investing approach is one constructed to justify the urge to give in to a Get Rich Quick impulse), Passive Investors tend to be highly defensive investors. They compensate for the irrationality of their approach by declaring it not only a rational approach, but the only rational approach. Declaring one approach the only rational approach of course closes the option of learning from all the other approaches developed by all the millions of other smart people in the world.

To embrace Passive Investing is to reject your capacity to engage in human reason. Don’t go there! Your need to justify to yourself your decision to reject your own capacity to reason will cause you also to reject the product of the reasoning power of millions of other investors traveling different paths to solve the same mysteries.

Passive Investing is a lose/lose/lose proposition. It’s not just that it leaves you financially poor. What’s worse is that Passive Investing is a way of thinking about the investing project that in time leaves the investor incapable of engaging in the intellectual work necessary to have any realistic hope of becoming a successful long-term investor.

Passive Investing — Bah!

Rational Investing is the Dr. Pepper approach.

I’m a Rational Investor! He’s a Rational Investor! She’s a Rational Investor! We’re all Rational Investors!

Wouldn’t you like to be a Rational Investor too?