Why there is no way to passively manage our monies – there is only how much we pay for it.
I find the whole debate about active versus passive investing amazing and in part, actually highly amusing. Mostly, that has to do with the fact that there really is no difference between them, and also because of all the reasons people give trying to justify doing one or the other. To be clear, every decision we make when it comes to our investments is active. Remember, in the beginning there is money, and a pot of wealth that needs to be invested. What, how and where we buy, are all things someone needs to decide. Even staying in cash and doing nothing is an active decision, because there is an opportunity cost and of course, which currency do we keep the monies in?
But let’s start at the very heart of the argument: By buying so-called passive index trackers, we can get exposure to a large number of stocks or bonds and we are foregoing having to make active decisions as to which ones to pick. The whole thing is quite inexpensive and it works really well. By some estimates, there is now more than $10 trillion managed in passive funds. But surely, it begs the question: what stocks or bonds are in the index? The very fact that we have an index, means that there are a set of rules, a model, and a decision as to which financial securities are put into said index. Just as it were if we paid an active manager to do the same thing.
There simply is no passive way to manage our money. The only thing we need to decide is how much are we going to pay for it. Think of it this way: if you were to drive to your local supermarket to buy some food for the weekend, would you take the Ferrari or the station wagon? Leaving aside the superior driving experience of the former and looking merely at the practicalities, the groceries we buy will probably be much easier to store in a car that was designed for such functions. Rather obvious you say? Absolutely, but then again Neil Woodford was managing £12 billion and the money must have come from somewhere.
The point is, we may have to make active decisions, but where we make them and how efficiently we execute is what really matters. If we want to put some of our money into stocks, there are two hugely important things we need to think about. First, how much of our total wealth are we going to invest? That depends on our circumstances, plans and the risk we want to take on. Ninety percent of our returns will be driven by this decision, so we better get it right. Not to worry, we can always rely on just allocating an equal portion of our monies to all of our investments. That way, we can at least be sure that we have spread our risk (please see our blog post One over N for more information).
Next, we need to pick our winners, and the temptation is to give our money to the gurus, who spend lots of time doing research and choosing which individual financial securities to buy. But remember this only accounts for 10% of our returns. Yet the fees are much higher. It costs ten times as much to have someone actively pick our equities or bonds versus buying passive index ETFs. Which ETFs? That’s a matter of opinion and in the end the markets are random anyway. So, if we are overweight the US or underweight small-caps is almost irrelevant. At least we are not paying someone else to get lucky. So the next time you are at a lovely cocktail party and someone asks whether one should invest actively or passively, just smile and ask if they could kindly pass the hors d'œuvres.