Jun 11, 2021
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The Dangers Of Passive Investing

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A Popular Investing Strategy Carries Risks

Over the past 15 years, the most powerful trend in investing has been the growth of passive investing, which is the long-term purchase of investment vehicles whose performance is linked to a relatively fixed set of investment instruments, such as a stock index. The appeal of passive investment has not been limited to individual investors but has been embraced by pension funds and other institutional investors. Unfortunately, it is this extreme popularity that may produce the conditions that could expose devotees of passive investing to the risk of significant losses in the years ahead.

The popularity of passive investment is understandable. Passive investment vehicles typically offer lower fees and the ability to quickly gain diversified exposure to a market or specific sector. Passive strategies are easy to implement and are intellectually undemanding. That 80% of actively managed mutual funds have historically not performed as well as broad market indices have certainly contributed to the appeal of passive investment vehicles. Passive investment strategies now represent almost 50% of invested assets versus roughly 10% at the turn of the century.

But there are dangers…….

It is noteworthy that the bulk of the growth of this pool of passive investors has occurred in a benign market environment. Except for the Financial Crisis of 2008, and the sharp but brief market decline of 2020, this growth has coincided with consistently positive market returns generated by unusually low market volatility. Thus, the experience of most owners of passive investment vehicles has been a steady march higher, with minimal volatility. Indeed, stock markets for the decade of the 2010s demonstrated extremely low volatility compared with historical averages.

The ease of use of passive vehicles has reduced the desire by many people to acquire the investment knowledge obtained by study and experience. Passive investment has thus created a large pool of investors with limited skills in coping with changing investing environments.

How will these investors respond to the volatility associated with a bear market when it inevitably arrives? Investors with modest experience of market volatility and negative returns may be more disposed to emotionally-driven decisions when faced with the psychological pain imposed by a significant bear market….and this creates greater downside risk for both the passive investor and capital markets in general.

Meaningful selling from holders of passive investments has the potential to amplify market volatility, which would generate further selling. The problem lies in the tendency of passive vehicles to concentrate their holdings in the components with the largest weightings, in a bid to replicate index returns most cost-effectively. This approach is understandable when one recalls that the top five companies in the S&P 500 represent over 20% of the index! An event that prompted sustained selling by passive investors would likely amplify the declines of market indices of the concentration of their sales in vehicles holding stocks with the largest index weightings.

Investors do not have the luxury of dealing in certainties but with a spectrum of probabilities. Our current era hosts an array of potential catalysts that could produce significant market volatility, Stock market valuations and investor optimism are at extreme levels. The global economy is burdened by an unprecedented level of debt and geopolitical risks are rising. While a variety of vaccines are available to combat COVID, the potential threat posed by the emergence of new variants should not be discounted. This combination of factors suggests that the 2020s will be a very demanding decade for investors.

I believe the answer to these demands lies not in passive investing, but for investors to become more engaged, more “active” in the management of their financial resources. The effort to become a better informed, more active investor will prove rewarding to both those who choose to make their own investment decisions and to those who prefer to have their money managed by others through their ability to ask better-informed questions of their advisors.

In conclusion, economic and geopolitical forces are converging that we expect will produce considerable market volatility in the 2020s that will ultimately reward active investors and punish the passive. Best results are seldom achieved by being passive in any aspect of life, be it our relationships, careers, health, or our investments.

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investing · investment · startup · stock-market · Trading

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