Recently, there has been a strong push within the investment community towards passive diversification of investments through the use of ETFs and index funds. With programs that offer incredibly low cost-basis fees, down to even 0 fees, it can seem quite enticing to own such broadly diversified securities.
The rationale behind general passive investing (through ETFs and index funds) is predicated on two factors. The first factor being that individuals will not be able to beat the stock market as a whole as it is highly efficient (aka efficient market hypothesis), where the securities themselves reflect true intrinsic value at any given moment. The second factor is that the economy as a whole will continue an upwards trend over the long-term, as innovation within a capitalist society will spark general prosperity. Given these two factors, we have emerged with a general consensus that leaving a bulk of your net worth within a broad-based investment fund such as the SP500, a target date index fund or a robo-advisor is a generally safe option. While it is true that the economy as a whole is mostly efficient with processing recent information into the price of a security, there are unspoken downsides with a traditional passive investment strategy.
Here are the downsides of traditional diversification through passive investment strategies:
1. Through the use of broad-based passive investments, your portfolio will be highly correlated with the general outlook of the stock market at all given times. While this protects you from the downside of being a poor “individual stock-picker”, your portfolio will also have a slim chance of being able to beat the market on a consistent basis. There are a number of quantitative strategies proposing to beat the market through analysis of macroeconomic factors or past data of volatility within various classes of securities. These types of predictions amount to shaky guesses at best. If someone was able to consistently “guess” the market’s direction in the short-term on a repeatable basis, they would be trillionaires. It is also equally suspicious to assume the next 10 years of a certain asset class will be similar to the last 10 years.
If we were to look at who is able to consistently beat the market over the long-term, we would find that it is not the “top-down” macro people who are consistently beating the market over the long-term. The people beating the markets consistently are often completing “bottom-up” fundamental analysis of individual securities. This makes sense because it’s much easier to figure out how an individual security will do over a long-term period than it is to figure out the entire direction of an economy over the short-term on a repeated basis. Basically, using ETFs and index funds, even if you have “specialized” strategies, makes it very difficult to beat the market, not factoring in the luck of educated macro guesses. The lesson here: broad diversification through ETFs and index funds is very likely to lead you to average results and prevent you from being able to achieve consistently better investment returns. If you’re fine with average results (and most people should be as it is difficult to beat the market), this should not be a problem. But for those with the ability to identify securities that will provide larger gains, or an ability to identify individuals who are capable of doing so, the average path would not be a reasonable option.
2. Because a traditional passive investment strategy is exclusively focused on the “long-term”, it is often rationalized that an individual could dump their entire excess cash into the stock market at any point and forget about it. However, if you were to dump your excess cash into the stock market at the peak of 2007 for example, you would find that you would have broken even by 2017/2018, after over a decade. While it is arguably true that over a long-term period of 30-50 years, this would be irrelevant but why lose out when this could have been avoided? This is the rationale that many investors ironically take when looking at these long-term investment strategies.
When resigning to a broad-based passive investing philosophy that invests in the market as a whole, the investor has a negative incentive to focus on the short-term and try market timing because their investments are recognizably subject to short-term macroeconomic factors. This incentive explains why many people are proposing in 2018 to put less money overall into investments because they are worried about a market crash. Overall, this reasoning is limiting because there could be good deals out there for individual securities that would not be as susceptible to market crashes, and would offer opportunities for stable dividends and future potential growth. Being able to identify individual securities that are already cheap would remove a need to try market timing. The other limiting factor is that the market as a whole may continue to keep increasing for a few more years despite all the predictions. Look at how many people were able to predict the Great Recession in 2008, has anything changed with our forecasting abilities since then?
While a lot of this writing was spent criticizing modern diversification strategies, it remains a good option for investors who want to automate the investing process and are truly in it for the long-term. But for those who are particularly susceptible to short-term fluctuations within the stock market or are interested in pursuing better than average market results, they would be better off with strategies such as value investing. This rationale is a large driver for the investing philosophy at Taher Financial Planning.