Passive Investing is an approach in which you stick with the same stock allocation despite wild price swings. It became hugely popular during the wild bull. Its popularity is now in the process of bringing about the largest loss of middle-class wealth in the history of the United States (presuming that stocks perform in the future anything at all as they always have in the past).
The Stock-Return Predictor tells us that, at a time when the P/E10 value is 8 (the value that applied at the beginning of the huge bull), the most likely 10-year annualized real return for stocks is 14.5 percent. At a time when the P/E10 value is 44 (the value that applied at the end of the wild bull), the most likely 10-year annualized real return for stocks is a negative 1 percent. There is no stock allocation that makes sense both at a time when the likely 10-year return is 14.5 percent and at a time when the likely 10-year return is a negative 1 percent. Passive Investing is irrational.
Lots of smart people think it is a great idea. How come?
Say that you began investing in stocks at the time when the P/E10 value was 8. You obviously enjoyed great returns for a number of years. As prices climbed, your common sense told you that you should lower your stock allocation a bit. A voice from your dark side (you greedy cuss!) said “no, hang on, this money for nothing business is too cool!” The Passive Investing enthusiasts told you to pay attention to that voice. You did. You enjoyed more years of great returns.
Passive Investing is addictive. It works. And it works. And it works. And it works.
And then it doesn’t.
That’s how it has always happened. There’s an important sense in which what we are going through today is nothing new.
There’s another sense in which it is new, however. What is new is that this time Passive Investing paid off bigger and for a longer period of time than ever before. We never reached a P/E10 value of 44 before. The number that applied in the month before The Great Crash of 1929 was only 33. We shot way past that bad boy in late 1999.
So Passive Investing worked better this time than ever before, right?
Not right.
Extreme valuations are bad for middle-class investors. Yes, you make lots of money on the up. You then give it back on the down. The end result is not that you break even. The end result is that you are conned into believing that you are wealthier than you are, you make plans for the future based on what you believe your accumulated wealth to be, and then you see those hopes crushed. Middle-class investors are better off if stocks go up a steady 6.5 percent real per year.
Our belief in Passive Investing caused the huge bull. Rational investors would never have permitted valuations to climb so high. Our belief in Passive Investing put our minds in a collective fog. We let things get more carried away than we ever have before.
Most are going to wait until prices crash to term Passive Investing a loser. Not me. The financial losses we are suffering now are just the inevitable result of the crazy price jolts we saw in the late 1990s. The real problem is the craziness that Passive Investing injects into the investing system during up times, not the financial losses that inevitably follow when we are seeking to find our way back to sane price levels.
That’s my take. I don’t need to see the price drops to conclude that Passive Investing hurts humans and other smart, fun-loving mammals. My view is that the losses we suffer in a wild bear are just a natural consequence of the insanity we yield to during a wild bull. The damage has already been done. Passive Investing failed in my eyes when it caused the insanity of the late 1990s.
Please don’t think that I wish these losses on anyone. That’s always the accusation leveled at those who talk straight on stock investing. I want us to learn enough about stock investing to avoid both the insane price jumps of times like the 1990s and the painful aftermath of such eras of insanity. I focus on the cause of the pain rather than the pain itself because it is only by focusing on the cause that we can hope to help people. Bemoaning the price drops accomplishes nothing unless we use that pain to change our behavior during price cimbs.
Passive Investing causes the insanity that does in stock investors. The insanity is behind us; we are now in the early stages of recovery from it. That’s why I say that we do not need to see the price drops to conclude that Passive Investing has failed. This low idea has already accomplished its dirty work.
Today’s Passion: The article entitled Rational Investing vs. Passive Investing offers even more mean-spirited commentary about the most popular investing strategy in the history the world.
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