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Indexes or Humans: Your Investment Boat

by Craig Moser on September 8, 2017

The decision to use indexes or human managers depends on whether you want a rudder on your investment boat.  Unlike the current headlines tout, good risk-adjusted returns don’t simply depend on low investment fees.  They also depend on sensible risk controls and management over market cycles.  To that end, you should understand how passive products work, especially exchange traded funds (ETFs).  You should also understand how successful active managers succeed in the long run.

 

Despite the dire headlines about the “average” actively managed fund underperforming its benchmark, there’s no academic consensus that passive is the way to go, nor much reporting on the above-average fund managers who have added value over time.

 

I find it interesting when markets are near or at the top of their trading ranges, arguments arise there is no need for human interaction in a portfolio.  They claim indexes are better choices.  When I look back at the end of the century (1999), it was the same way.   All you needed was the S&P 500 and some internet stocks.  Suddenly you were making crazy good returns.  The same scenario played out from 2007 to 2009 with similar results.

 

Your Investment Boat

Investing in these indexes is like having a boat without a rudder.  All you can do is ride the highs and lows of the tide without the ability to steer.  There is euphoria at the top and desperate selling at the bottom.  Or, you may just wait it out for your money to recover years later.  As always happens, “it works until it doesn’t.”  The markets give back a significant percentage of those great market gains.   If you think about how this typically plays out, it is kind of interesting.   Losses only occur from the tops of markets and gains pretty much occur from market bottoms.  So why is it people are so afraid of investing after a market bottoms and enthusiastically invest at or near market tops?

 

Even as he claimed victory in a $1 million wager that an S&P 500 Index fund would beat a high-cost fund of hedge funds over a decade, Warren Buffett, in his 2016 shareholder missive provided many investment chestnuts related to Berkshire’s stock-picking and active management more generally:

 

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold.  When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not tea spoons.  During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases.  Second, personal fear is your enemy.  It will also be unwarranted.  Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.”

Sound Advice

 

Buying when the market is gripped by fear is sound advice.  So is advising caution when asset prices reflect irrational exuberance.  Yet passive investing in bull markets compels just that.  Mathematically, as the share prices of index constituents rise, passive investors must invest more in them to maintain their respective weightings.  In essence, passive investing becomes a momentum play.  And the dynamic works in both directions: as indices fall, passive investors must sell into a declining market.  Rather than buy low and sell high, passive investing does the exact opposite.  It makes no economic sense.

 

Charting Your Course

My take is that investing requires you to chart your course while remaining flexible.  When markets start to decline beyond normal ranges, you should consider moving assets to a safer place.   I know it’s easier said than done.  However, with the advent of quick as lightning algorithmic formulas, you can increase your odds of success by using math.  While math plays a really big role in improving your odds of success, I believe the human element also gives you an edge.  You just need to remain true to the set of rules that you follow.  Even Warren Buffet event has rules he follows.

 

As I look at strategy it’s important to align your strategy with your current stage in life.  If you have 10-15 years before accessing your savings and investments, your investment goal should be growth.  If you are systematically adding to your investment, the impact of normal market declines helps your overall long term return.

 

On the other hand, if you’re withdrawing from your savings and investments to pay for your retirement, the opposite can occur.  You can have an account loss magnified by a withdrawal at the lower value.  In this scenario, your withdrawal plus the loss creates a situation where you may need to adjust future withdrawals.  In short, your level of risk should be tempered by your requirement for cash flow and your stage of life.

 

Indexes

If you’re still totally comfortable investing without a rudder, you should definitely consider index investing.  You will get full exposure to whatever index you choose with minimal costs.  You will also get almost all of the return of the index chosen.  However, there will be no one there to protect your principal during downturns.  You will also get full exposure to any loss as well.

 

For those you cannot stomach losses outside of a mild correction, you need to consider your approach carefully.   Do you have a rules based strategy?  Are you just hoping your investment(s) go up irrespective of economic changes?  If so, I suggest finding someone who can show you how to minimize downside risk and preserve what has taken you a lifetime to accumulate.   Luck favors those who are prepared.

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