28 Feb The Horrors of Passive Investing
The Horrors of Passive Investing
February 28, 2018
Nobody wants us to trade.
Warren Buffett still believes in trading, but only for smart people (not us, in other words). For regular folks, passively investing in index funds is the way to go.
Active traders are losers (according to the experts). High fees decimate the returns of active funds and stock-picking is too hard anyway. And trading anything other than stocks is just throwing money down the toilet.
No, the experts want us normal people to buy into an index fund and keep doing that forever. That’s by far the best (and only) way get ahead.
But the experts don’t tell us about the dark side of passive investing. Spoiler alert: it’s a horror show.
The happy image of index fund success is serene and lovely. The stock market always goes up over time, and if we buy into a low cost index fund regularly, our money will go up over time. Everybody wins forever.
But what about the times the market doesn’t go up? I know that’s unthinkable these days, but I’ve heard rumors that the stock market does go down sometimes.
If it goes down, what happens to an index fund investor? Nothing good.
As a passive investor, you have no recourse. If the market goes down, so does your retirement money. So does your life savings. So does the down payment on your house.
It all goes down, and there’s nothing to stop it. No stoploss to end the pain. No ending point whatsoever.
Psychologically, it’s a relentless barrage of sadness. And the losing preys on one of our biggest fears: lack of control.
Why do people hate flying? They hate it because they have no control over the outcome.
Passive investing, in the down times, is a person petrified of airplanes being forced to fly every day for weeks or months at a time.
But that’s not all.
For whatever reason (I blame the experts’ constant index fund cheerleading), passive investing has grown tremendously in the past few years. The passive market share of US equities has risen from only 12% in 1998 to 46% at the end of 2016.
Forty-six percent of the market now consists of passive investor money–all doing the same thing. Half of the US market is all in one basket!
Guess what that means?
It means massive acceleration to the downside when things go poorly. Research has shown that markets fall much faster than they rise (possibly up to three times as fast). That’s bad.
And now half the market is in the same boat? That’s worse.
The psychological trauma and money loss is potentially much worse now than it’s ever been.
But that’s still not all.
Many passive investing programs now offer emergency get-out points. Investors can decide that they want to get out if the market has a 10-50% loss.
That seems safe. When the market drops, however, these portfolio-saving measures help the downward spiral accelerate even more. And, again, because of the growth of index funds, there are fewer and fewer people around to take the other side of the trade.
Passive investors all go down together in bad times. And they go down hard.
This can lead to a panic that pulls people out of the market (locking in their permanent loss). That can lead to a panic that makes even the hearty souls that stay in not see any profit for years (maybe even a decade).
Last, passive investing limits the upside.
The best year for the market in the past two decades was a 37.6% gain in 1995. In fact, the market has only been above 30% five times in twenty years and only once in the past decade.
We can feel the helpless torture of seeing a 50+% drop but probably will never see the joy of a 50% gain.
Being a trader can solve all that. Having a stoploss stops the bleeding. Losing is never easy, but it’s psychologically easier when we know it has an end point.
Plus, having a stoploss allows us to manage risk with our trade sizes and also allows us go for the big win.
Trading can potentially give us huge winning years. Passive investing never will.
And that’s why a 20% gain using a trading system is way better than a 20% gain on an index fund.
It’s the same amount of money, but trading has a purpose, a plan, and way more future upside. Passive investing has blind hope, the fear of uncertainty, and limited winning.
And it’s that huge upside that comes with trading that we’re going to be talking about in coming weeks.