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Passive Indexing – What Dirty Harry and Investing Have in Common

September 21, 2013

dirty harryI know what you’re thinking, punk. You’re thinking “did he fire six shots or only five?” Now to tell you the truth I forgot myself in all this excitement. But being this is a .44 Magnum, the most powerful handgun in the world and will blow you head clean off, you’ve gotta ask yourself a question: “Do I feel lucky?” Well, do ya, punk?

Harry Callahan, The Motion Picture “Dirty Harry”

Active vs. Passive – the age old debate that misses the real issues.

One of the most common and often heated arguments among investors is on the discussion of active versus passive investing.  The passive investors will argue that, since most active managers do not consistently beat their benchmark, that investors should simply buy index funds  and call it good.  The passive crowd includes some heavyweight names like Bogle, Ellis, and Burton and fund families such as Vanguard and Dimensional Fund Advisors.

Passive indexers believe that the markets are efficient and that the goal of every investor should be to capture the markets returns at the lowest possible costs.  I will concede that (a) most managers do not consistently beat their benchmark and (b) markets are generally efficient. But does this mean I think investors should follow the passive approach?  No, No, 1,000 times No!

I have long believed and discussed within this blog that the whole argument of passive versus active misses the point and is just noise compared to the bigger issues at hand.   Those issues are (a) That investors need to save more than they spend so as to be able to accumulate sufficient assets for the future and (b) that investment, i.e. market returns, are random, and that the sequence or distribution of market returns is absolutely of critical importance to investment planning.

To this latter point, I want to steer readers to an excellent post by Dr. Wade Pfau who has written some excellent papers in the area of retirement income planning.   Wade’s most recent article, “You Can’t Control When You are Born…Revisiting Sequence of Returns Risks” address my concerns square on.

In the example Mr. Pfau provides, he displays the following table showing investment results for 151 hypothetical different investors who save the exact same amount of money and experience the exact same average return.  The only thing different is when the investor begins and thus, what sequence of returns that the investor experiences.  Though they could expect wealth equal to 10x their salary, the outcomes ranged from a minimum of 2.98x to a maximum of 27.7x.  The difference in results is only explained by the order in which the returns occurred.

wade pfau

To quote Dr. Pfau, “This is sequence of returns risk! People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.”

This readers, is why I am so adamant that a prudent investment policy must include active risk management, and this is why each of the Portfolio Cafe models are built with a risk management component.  For an investor who experiences a significant portfolio loss late in their investment cycle, it is quite possible that the investor will never be able to fully recover and thus be able to experience the retirement lifestyle they had planned.  Since none of us know what the future returns of the market are going to be, our only other choice is to make sure that we follow an approach that can reasonably protect our portfolio from large losses.

The active vs. passive argument focuses your attention on whether or not your returns are “as good as the benchmark” but it says nothing about whether or not the benchmark returns themselves will be adequate in magnitude or in a sequence that assures your investment goals are met.

So the next time someone suggests to you that you should just go buy an index fund, ask yourself, “Do you feel lucky?  Well do ya…?”

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