The Passive Investment Problem

Buy it, hold it and forget it is the idea behind robo-advisors and is the reason that robo-advisors are detrimental to your financial health and well-being.  The hype behind robo-advisors comes from the advisors themselves who are determined to get your money out of the bank and onto their platforms.  When the market turns down, robos are going to have a lot of unhappy customers.

I spent more than 25 years representing investors who had been ripped off in the financial markets. In most cases they knew just enough about investing to get themselves into trouble.

One of the reasons that I write this blog is my desire to point out foolish investments and investment advice.  Much of that advice, because it is repeated over and over by an industry with a massive advertising budget, becomes “common knowledge” even though it is without a solid basis in fact.

Most professional investors use what is called fundamental securities analysis to make a determination of what stocks to buy and at what price they are willing to buy them.  Fundamental analysis was developed by Prof. Benjamin Graham in the late 1940s and his textbook is still used in business schools all over the world.

Fundamental investors analyze a company’s income statements and balance sheet. They look at its management, products, competitors and prospects for the future. The question they are faced with is the same question all investors face: if I buy this stock today, will the price go up in the future?

It is important to understand that this analysis is not an exact science.  What is more, markets are as often as not driven by irrational forces, fear and greed, as anything else.  Even some of the basic macro-economic factors that drive the markets such as interest rates and oil prices are political decisions, not rational ones determined by supply and demand.

But that is not a reason to give up on a rational, analytical approach to investing or stock selection.

The idea of passive investing has gained some traction of late for the wrong reasons.  Passive investing is the idea that you “buy and hold” a stock or a fund no matter what happens.  The theory, at least for investors with a long time horizon, is that the investment will be worth more when you need it, years in the future.

It should not take you long to realize that no one can predict what the market price of any stock will be years in the future. Fundamental analysis looks out a year or so and even that is difficult.

That “no one can predict the future” is one of the reasons that people advocate passive investing.  But their “buy, hold and it will be worth more when you need it” strategy does just that.

Advocates of passive investing will point to a number of academic studies, most from the 1990s that suggest that mutual funds, which are actively managed, failed to beat the market indexes over the long term.  These studies exist but are flawed for a number of reasons.

In the first place, beating the market index should never be the goal of any small investor.  To beat an index means that you will need to take risks that are higher than the index and those risks will often come back to bite you.  That is one of the reasons that mutual funds, the active investors that these academic studies are looking at, do not, on average, perform as well as an index.

The other reason is that mutual funds are not efficient. They are constrained by law, their own advertising and the ebb and flow of funds in and out.  Mutual funds are also subject to advertising costs, sales charges and management fees.  They should always yield less than a theoretical index that is not subject to these charges.

Notwithstanding, the passive investors are quick to repeat that the average investment advisor cannot beat an index.  I do not know why anyone would hire an “average “advisor or why any investment advisor would bother trying to beat an index.

Your goal should always be to have more money in your portfolio this year than last year and more again next year.  The way to accomplish this is to do the one thing those passive investors will never do, sell your positions when the market starts to go down.

How can you know when the markets are starting to go down? Fundamental analysis works both ways; it tells you what to buy and at what price and what to sell and when to sell it. Even if your analysis is wrong, there are ways to protect your portfolio against losses with stop-loss orders that get you out before you have given back all of the profits that you have made.

No one can predict when the market will peak. People can get greedy and fearful that if they get out now, they might miss another year of profits.  Of course, even if the market does go up for another year, two years from now it may be at levels below where it is today.  That means that you will have less money and be two years closer to retirement.

Investing is difficult. Fundamental analysis is a skill that takes time to learn and is time consuming for anyone.  If all you had to do to make money in the stock market was to buy an index ETF and leave it alone, everyone would do it.

Passive investing in general and robos in particular are for people who do not know enough about investing to do it well.  If you consider yourself to be in this group, either hire a competent advisor to do it for you or leave your money in the bank.  Anything else is foolish.

 

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