Assessing some risks of Passive Investing

Two weeks ago I asked Sven Carlin on his Youtube channel if passive investing could even be considered real investing. He answered that yes, it could, but only if done with the proper long-term approach, where most people fail. He was a gentleman as always. Other people, not much so. I detected, then, a certain aggressive posture here and there, like if I should not even question the matter. Being who I am, I took that as a good challenge. Forbidden subjects are like baits to me, I can’t resist. I know the whole argument to point out the dangers of active investing, like stock picking, from Bogle to Ramsay, etc. But what about the risks of passive investing? Can’t we assess them? Shouldn’t they be assessed?

Full disclosure: I am a fan of active investing and a practitioner. That being said, I know very well the many risks of doing stock picking, and knowing the risks and dangers actually makes me more prepared to deal with the thing. Passive investing should receive the same scrutiny, for the sake of its own users. That is what I want to understand here. I can’t stand the idea that Passive is necessarily safer, and that idea is just one of the most compelling arguments to sell the strategy. We need to think about this.

Investing as buying property to generate value

Living in this world for almost four decades now, I get to understand some things. For example, experts love to derange our clear thought with their specialized mumbo jumbo. This goes in all fields. To be frank, I don’t believe it is necessarily some dishonesty on their part as specialized people, as much as it is simply irresistible to go with fancy language tricks to feel empowered and superior. We, humans, are full of this prideful shit. We face a war to keep things simple and to be humble.

Regarding financial matters, the fight for simplicity goes on. I think a huge contribution can be done by defining investing in simple terms, like: to invest is to do the acquisition of property to generate value. This works fine for me. And it is a tool to check if someone is trying to sell me something that has the name of investment, but actually doesn’t look so much to be that.

The entire financial industry works over the lack of organization and education of the masses. On the debt side, discounted large enterprises, the retail borrower in most cases shouldn’t be getting any debt in the first place. And in the investment side, many retail customers pay for products that empower the institutions as intermediary agents without any guarantee of increased results or decreased risks.

Paying for his pure ignorance, the “investor” gives his money, which was his responsibility to earn and save, to institutions that are supposed to know better how to deal with the complicated business of investing. To me it is flagrant that we have a conflict of interests here: all investment choices in this relationship need to be convenient now for the TWO parts of the deal, the customer and the institution. In theory, their interests are aligned, but can we be sure that happens in the concrete reality? I am not that sure.

Why a person that outsources investment decisions should be considered an investor?

To me, looks more like it is just a saver. One earned and saved, and now puts those resources in other hands to be invested. And if the person owns rights over a financial institution, that doesn’t mean the person holds the actual property. The institution does own property and receives the value generated for investing. The client of the institution owns a contract like a bond and receives part of those results.

Passive investing is more like indirect investing, but what does that even mean? Do a taxpayer “invest” through the appliance of his resources by the government? Does a lender “invest” through the funding of the borrower’s profitable activities? I guess not.

My radical approach to this is: only active investing is real investing because it is the purchase of property that generates value to the owner in return.

Passive investing, in my broad definition, is not only following a market trend or Index, but outsourcing both the direct ownership of the property, as well as the decision making process of investing (what to buy or sell, when to buy or sell, and at what price).

I am not going to waste more of your time with this argument though. I know most people care only about the practical aspects, so here we go.

Funds: better for who?

In practical terms, the financial products work as a share of interests between the customer and the intermediary agent, the institution.

The active investor has one problem to solve: to get some risk to get some returns.

The passive investor has two problems to solve: to get some risk to get some returns to him, and also to get some returns to the institution.

The important thing to remember is that it is the institution that is going to make the operating decisions in this relationship. From the moment that the customer’s money gets in, to the moment that is pulled out, the institution makes all the calls.

The price to be paid here by the passive “investor” is not only the fees. That alone can be a big thing to discuss, and we will talk more about it going forward, but for now, I want to point out the price paid in terms of conflict of interests.

We can talk about the sound example of Goldman Sachs in the 2008 debacle. Later, Congress asked the bankers why they sold products to their customers that themselves literally regarded as pure crap. And even worse than that, if they see any misconduct in making side bets against their customers to profit even more over their ignorance. The bankers replied something like this: we always do that, it is business as usual.

And that is my point.

When it is possible –and I guess that for the most part, it is– to make money for the two parts of the relationship, that will be done, of course. Everybody goes happy when things are fine. And indeed passive “investors” can get very successful with their “investments” in the long term. This is why it is a waste of time to try to prove me wrong in this subject by pointing out real results. I don’t care. It’s like the crypto discussion: all fundamentals are thrown out the window with a returns chart. What is the point of discussing returns, if the matter here is the constant that will prevail after the chart changes?

So, funds and other financial products alike can be good for both parts when things are good but can be very damaging for one of the parts when things start going wrong, like a partnership or a marriage where all defects can be tolerated when things are fine, and the same traits are unforgivable when the situation changes.

That is the problem with a conflict of interests: in most cases, you have to look for it to find it.

When the tide turns fast, it can be too late to do anything about it.

Stock picking and Diversification

Why does stock picking means automatically asset concentration in people’s minds?

It is because stock picking became synonymous with deep studying that takes lots of time and is incompatible with diversification. Indeed, that happens in lots of cases with professional investors that do extensive research and that follow closely their investments. They do only a few deals each time.

But there is a hidden catch in this concept. A person can actually do stock picking and pick lots of stock for the sake of diversification. That just can be done. With that, the investor can own property directly without intermediaries, collect nice returns, and manage risk with proper diversification. Why that seem odd then?

Because we have Index Funds and ETFs to do the job for us, of course. Why should one have the trouble of selecting assets, and then buying them and managing all of that, if one can just give them money for an institution to do all that for a small fee?

Again, the arguments that look the most practical seem to win. But stubborn people can get around this and double-check the reasons to do it and to not do it. To me, the pressing problem is the same with mutual funds in general, the dormant conflict of interests. But a case can be made also around returns and costs. Let’s check that out.

The weakest reason for stock picking: Returns

There is a study that shows that if you select stocks by a few objective and simple factors –especially profitability, but also levels of debt and time as a public traded company–, the chances are that you can have better returns than the market average, and in long term (15+ years) you can actually make substantial better returns then an Index, for example.

Despite that, I think the comparison of returns is the weakest reason to chose stock picking, because of:

1) Returns can tell any story you want them to tell. People always underestimate the power that statistics have to lie, or, saying better, they underestimate the power of their own beliefs to drive the discovery of the facts that just confirm their wishes;

2) In investments, it is much more important to assess and manage risks than to calculate the expected returns. You can always make less money, but you should never lose money.

That said, Indexes are indeed stupid and generate mediocre returns. I really think it is not a big brainer to generate better returns with stock picking using simple indicators, in the very long term (20+ years).

The medium reason for stock picking: Costs

The old 2/20 fee rule for Mutual Funds has devastating effects in the compound effect.

Since people make lots of money in the long term, they don’t care much to look for the cut of the institution, which is actually part of THEIR money going away. That has a simple psychological explanation: the fantastical returns seem to be a work of a genius, and geniuses must be well paid. People confound the pure power of compound interests in the long term with the cunning of the managers. Literally, they pay for their ignorance.

This reminds me of the confusion that fixed income “investors” do with Bonds. When the financial volume is big enough, in the long term the interests earned can look more than capable to pay for a comfortable retirement with a safe margin of security. The problem is that the economical truth behind this success is the much lower real return with the discount of the real inflation that all governments omit. That return can be close to zero, and sometimes can be negative. The truth, though, is buried under a big fancy pile of cash.

Like the truth about the costs of Mutual Funds in the long term: it is buried under the happy results the client made. A certain study showed that after 20 years, most of the Funds with the 2/20 fee structure make more money than their clients: at least 50% of the total returns have been collected by the fund.

You can throw at me the much cheaper costs of Index Funds and ETFs, like 0,5%. Of course, this is much cheaper, but it is not free. If you put that in the long term, it begins to look scary too. And since Indexes are so stupid that you can sort yourself a better selection easily, what is the reason to pay for getting the worst results? Laziness?

The strongest reason for stock picking: Risk management

For the most part, things go fine in the markets and everybody is kind of happy.

From time to time, though, a crisis emerges, and they put such stress into the system and can bring such unpredictable results in the aftermath, that this simple risk is enough to put masses of people out of the financial markets forever.

To this day, even after so much share of knowledge and experiences, a very large portion of the public still thinks about the Stock Market as a place to gamble, or like a rigged system. And that is because crises always came and make their big mess, generating panic.

The panic really torments only the gamblers, being the ignorant trend followers looking for easy money, and/or, the operators that use leverage extensively. These are the players that will become mad and will denounce the system as rigged, etc. They are whining gamblers that lose their bets.

Investors buy property to earn returns in the long term. Short-term crises are good for investors because they can pay cheaply for the property they want to buy. What is a panic for some, is a firesale for others.

But let’s check now the power of crisis management that the passive “investor” has: he can pull out his money. That is it. He can’t choose to buy what is cheaper.

And not even the institutional manager can do that for him, because amidst the panic lots of people ask for withdraws, all at the same time, and the turnover rises. Much more cash gets out the door then comes in. That means two things:

1) the passive “investor” is not going to buy cheaper in the best moment the market offers to do that;

2) the passive “investor” is going to be forced to realize losses with the fund, just in the worst possible moment to do so.

Oh, but if he holds what he still owns, things are going to be better in the long term.

Yes, of course.

But here is my question: how much it is going to be better compared to someone that did the opposite thing in the crisis, i.e. not sold anything and bought lots of cheaper property?

You can imagine.

And here is an interesting thought to consider, one that I could ask Sven Carlin to think himself about: what are the chances, comparing to active investing, that a passive “investor” has to actually resist the crisis and hold for the long term? What is that person holding, again? A share of a Fund. But what is that? During the crisis, that can mean a very elusive vague thing.

If I own Coca-Cola, for example, I can hold it during a world war, a pandemic, whatever, just thinking this: we are all still drinking Coca-Cola every day to the end of the world.

What is going to be the passive “investor” thoughts about the funds he owns?

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