Should You Be a Passive or an Active Investor?
One of the challenges I have found with much of the analysis of investment philosophies is that it treats the two competing camps of active and passive management, as if every investor fits neatly within those two groups. The reality is that most investors fit somewhere in the middle. In this piece I want to explore the many shades of investing, and why pursuing a more "active" structured, evidence based approach is superior.
What is Passive Investing?
Passive investing is traditionally built on a philosophy of efficient markets. Investors in this camp typically buy Total Stock/Bond/International Stock market index funds and rebalance periodically. Investors who follow this pathway aim to keep their costs low, buy the whole market using market cap weighted indexing, and invest for the long run. This approach also lowers the risk of style drift, and allows for minimal cash drag. John Bogle and the Bogleheads made this approach popular.
There is much that I agree with in this approach. Keeping costs low is one of the principles of outstanding investors that I will analyze more in depth below. However, relying on market cap weighted indexes has many disadvantages which were outlined in a series of pieces by Larry Swedroe. You can check them out here and here.
One additional concern I will bring forward is the notion of pricing. When you buy a market cap weighted index such as the Total Stock Index you are buying more and more of a security as its price rises. This may lead to vast over weight positions in a handful of companies. While it is true that if you are buying a total stock index you own thousands of companies, it seems like a poor investment strategy to be purchasing more and more of a stock as its price rises. This is not a trivial concern. So there are issues with indexing which requires a better solution.
What is Active Investing?
I want to begin my analysis of active management by breaking active investors into three categories:
Speculators, High Cost Closet Indexers, and Passive Active investors which we will further break down into two categories, Warren Buffett Active Investing, and Fama/French Five Factor Modeling.
Speculators are a large group within the active investment arena. They are characterized by stock pickers, and are typically hot managers one year and gone the next. They generally charge high fees, and exhibit high turnover constantly looking for that one stock to "beat the market". Further evidence against these speculators comes from a statistical analysis of their stock picking ability, which will likely show the vast majority have no investment skill and when they do beat the market it is likely because they were lucky. I avoid these speculators and you should too.
High Cost Closet Indexers are so called active funds that are largely made up of their index constituents. Their R-Squared (a measure of how much of the return can be explained by moves in the index) is very close to 100%, indicating they are highly correlated with the index. They tend to have low active share, low internal ownership, and high fees. I avoid these funds also.
The final group of active investors we are going to split again into two groups the first being those who practice Warren Buffett style "active" investing, and the second being those who follow a structured investment philosophy that relies on the Fama/French Five Factor model.
Warren Buffett's investment philosophy seems to be misunderstood by the vast majority of active managers who claim to follow it. Warren Buffett bought Coca-Cola (NYSE:KO) in 1987, and he still holds it today. That is an investment. I can name several other holdings he has that fit the same pattern. The vast majority of active managers are turning over their portfolio at a frequency that can only characterize them as speculators. Warren Buffett buys fantastic businesses at a reasonable price and holds them. He is not turning over the portfolio every year, or even every two years. This is what active management should be. If more active managers lowered their fees, and actually followed Buffett, one wonders if they would have such a horrible track record.
The second group of passive active investors are those who follow a Fama/French five factor model as the basis for creating a structured portfolio. These investors aim to design a portfolio to capture the sources of outperformance that academic research has identified. I explored this in depth in my piece "Exploring the Science of Investing". This is my preferred core method for building portfolios for the long run.
What is the best approach to investing? Active, or Passive? Both.
John Bogle spoke about having a dream fund that would hold the top 40 companies in perpetuity. In this manner, John Bogle and Warren Buffett, two investors who have always been characterized as being on the opposite sides of the investing debate are actually well aligned. I have been reading Warren Buffett's investor letters for decades, and it has been the greatest education in investing I have received. Reading is an indispensable activity that far too few people engage in regularly. The insights I have gained from reading academic research, texts, and investor letters of some of the most famous investors of the past and present have taught me a great deal about the markets, how to invest, and many times how not to invest. From the combined wisdom of the greatest investors I have come up with five principles that characterize the best approach to investing. I present these with the knowledge that the idea of "best" is rather subjective, as different approaches work for different individuals' circumstances. I have made the case for why I believe a "passive active" structured approach, using the Fama/French Five Factor model through DFA funds, is the best core approach to investing. Still I know not everyone will choose to invest this way. And so I believe there are five principles that if followed will set you up for success, regardless of how you choose to invest.
1. Keep Costs Low- This is probably the most important of all of the principles. Investors do not fully understand the corrosive impact of high fees on their ability to build wealth. Whether you are pursuing a passive or active approach to investing keep your total costs low, including expense ratio, turnover, cash drag, etc. I laid out a more extensive case against high fee active managers in A Quantitative Analysis of Active Management." If you are going to trust an active manager even with all the evidence against it, then do your homework on the structure of the firm, their internal stake in the funds, strategy and again cost, cost, cost. Dodge & Cox might be the ideal active manager, even heralded by John Bogle himself. In my view judge any active manager against their firm.
2. Avoid Costly Behavioral Mistakes- When constructing a portfolio make sure it is something you can stick with over the long run. Own the level of equities you feel comfortable with in good times and bad. Costly behavioral mistakes will cost investors over the long run. I can't tell you the number of stories I hear of people who got out of the market in 2008 and never went back. They have missed the rally of a lifetime that has seen the S&P 500 and the DJIA more than double, reaching all time highs. This will have very serious consequences for these individuals' ability to fund their retirement and other goals. Managing your emotions is key.
3. Follow the Research- Academic research has clearly shown a premium from value stocks over growth stocks and small cap stocks over large cap stocks, especially when you control for quality. Regardless of your approach, including these types of investments in your portfolio will likely lead to outperformance over the long run.
4. Stick with Your Plan- Once you allocate assets, and begin investing, stick with your plan for the long run. Remember that in the moments where it gets most difficult (when prices fall) is when you will likely make the most money in the long term by continuing to invest and sticking with your investment strategy for the long run. Stay focused on what you want to do with your wealth. Maybe it's funding retirement, maybe it's funding college for a grandchild, or giving money to a cause that is close to your heart. Stay focused on your dreams and goals, and not on the short term swings of the market.
5. Keep it Simple- Investing does not need to be complicated. The vast majority of investors would be well served by a simple asset allocation that tilts their portfolio towards the sources of outperformance. This can be done in many ways, though I have clearly articulated that the best way is through a fiduciary financial advisor. Still, even DIY investors can put together portfolios that, while imperfect, will still serve them well if they stick with it for the long run. Life is complicated; investing shouldn't be.
I believe the debate about passive vs active investing is the wrong one. Investors should be far more concerned with investing according to a set of principles that keeps costs low, is aligned with their risk tolerance to avoid costly behavioral mistakes, tilts toward the sources of outperformance identified by academic research, and is allocated in a way that allows them to stick with them for the long run.
Once you have constructed a portfolio you are happy with, relax and enjoy your life knowing you are invested for the long run. I have been very clear on the importance of using a fiduciary financial advisor. If you are prone to costly behavioral mistakes, such as engaging in market timing, or giving up on the factors when they have a stretch of underperformance, then a fiduciary advisor would be even more beneficial. Regardless of how you choose to pursue investment success, following these principles will likely increase your chances of reaching your long term goals with your wealth.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.