Is passive investing going to destroy the stock market? There has been much chatter on the internet lately about the perils of passive investing and its ability to ultimately take down the stock market. Michael Burry, of the big short fame, recently stated he believed passive investing was a bubble, and ultimately would cause the market to crash. The article raised strong passions among many people.1 However, I think everyone is overlooking the root of this debate.
Random Markets
Passive investing springs out of the mindset that stock market results are random and unpredictable. If they are random, and the markets are efficient, what’s the point in trying to pick stocks or time the market? Just as you can’t predict or time coin flips, you can’t predict or time stock returns. Therefore why take an active position in the market? Just buy a bunch of stocks, maybe 500 of them, and hold them for a long time.
Passive investing comes from the realization that nobody knows what tomorrow will bring.
The growth of passive investing stems from the growth of this “passive” mindset. Over the last 20 years, investors have seen two large drawdowns in the stock market. Most “active” managers did not reduce the pain of these drawdowns, even though the investor paid them a sizable chunk of their wealth. If an active manager can’t reduce this pain, what’s their point really?
Investment Managers Don’t Help.
A funny thing, during most drawdowns, active managers often become very “passive”, at least when it comes to their advice to their clients. Every drawdown – and we saw some of this in August, – there is a chorus of “stay the course”, “stick with your plans”, “trust the process”, and “don’t sell, the bottom might be tomorrow”.2 All code for, stay passive, don’t actively move your money away from me.
Problem is, hear this enough and one thinks, if my investment manager is asking me to be passive when it really matters, and if they don’t really know what’s going to happen when the shit hits the fan anyway, why am I not investing passively all the time? Which leads back to the foundation of passive investing. If nobody really knows what’s coming, why don’t I invest as if no one knows what’s coming?
An Example.
I have a friend and former co-worker who ignored the stock markets most of his life. Too focused on work. But he retired a couple years ago, and with time on his hands, and no money coming in any longer from a job, he started watching his investments and the market. From an investing stress point of view, 2018 was awful for him. He just couldn’t understand the lack of reaction from anyone managing his money during the market fluctuations.
In February he talked to his investment manager: “That was quite a drop. Do we do anything? Stick to the plan you say. Got it.”
In Early November, “What are we doing about the market falling? Nothing? Bottom could be in? Ok.”
In December: “What are we doing now? Still nothing? Stay the course you say? Trust the process? Do you ever respond to the market?”
So he asked around to his other retired friend’s experience with the people that handle their money. Same answer.
Now my my friend wouldn’t have a clue himself what to do during these downturns. He wasn’t looking to time the market or sell. He was just looking for answers. And he realized, most investment advisors are not actively trying to prevent drawdowns, they are not actively repositioning during drawdowns, they are only actively trying to get their investors to stay passive during drawdowns.
The Preferred Way to Invest Passively.
As I’ve laid out in the blog, I don’t believe markets are actually random. But I personally have no idea how to predict future returns, and I don’t really think anybody else can either. I believe the efficient market theory is mostly correct if you view it through a geometric lens. Therefore, I might as well believe markets are random.
I also believe Geometric Balancing, my investment strategy, is the ultimate “passive” investment.
Most come to the realization that no one really can predict the stock market, decide to invest passively, and just buy an index fund and forget it. The thing is, if markets really are unpredictable, a mathematically preferred way to invest does exist. Yet nobody follows it.
Geometric Balancing
My strategy, Geometric Balancing, makes no meaningful guess about future returns. I have no clue what’s going to happen tomorrow or next month in any asset.3 Asset returns over any short time frame are extremely unpredictable. However volatility is fairly predictable. And correlation is slightly predictable. And I know that investing is a game of repetition.
Therefore, even though you have no idea if the market is going up or down tomorrow, you can build a portfolio prepared for the amount of randomness coming tomorrow. Because of the power of random compound interest, this actually matters. A lot.
With a “passive” mindset, it’s very possible to achieve returns matching the greatest hedge funds in the world. You will come out way ahead by simply focusing on the geometric average and the power of rebalancing. If you believe in passive investing, keep reading my blog to learn how to perfect the practice.
1-I also find this fear of passive investing silly.
2-I’m not saying they are wrong with this advice. But it does very much undercut a disdain for passive investment.
3- You can do a decent job predicting returns over a long time. See Schiller CAPE ratio as an example.