Is there even such a thing as a simple passive investment strategy?
Before rushing into ASX index ETFs or index hugging low fee LICs, there are many behavioural biases to think about. I will explore below what you should think about first to better equip yourself to this popular strategy.
Firstly, let’s get started early with the obligatory Warren Buffett reference you always come across from any financial article in the media. (Hey at least I didn’t put it in the headline with a huge picture like most do). I consider a key driver behind the popularity of ETFs in recent times is due to media attention given to Warren Buffett’s Berkshire letter in 2013 that discussed a strategy for the trustee for his wife’s inheritance. It was to place 90% in a low fee US equities index fund and 10% into short term government bonds. The four years since has seen a large portion of active fund managers under-perform the S&P500, which has added to the popularity of such a simple approach. Then there is the publicity surrounding Buffett betting that an S&P500 index fund will beat hedge funds, for a second time now.
I wish to make it clear I am not necessarily arguing against this method. I just wanted to point out that using simple strategies such as this will only succeed if you have the temperament to stick with them. I may be feeling my age but I have noticed younger investors embracing such strategies. Overall it is good to see them taking an active interest in finance and I can understand why ETFs prove popular amongst them. For those investors that didn’t have much of their wealth in the markets in 2008, they must look at the underperformance of active managers and wonder why everyone doesn’t go down the passive route. They probably have a healthy dose of scepticism to paying fees, and technology has seen new innovations such as robo advisors appeal to many, removing a lot of the hassles and costs of investing.
In choosing a simple passive investing approach though, you have arguably made a complex active large investment bet. Let me explain.
On what basis for example, may you have chosen the approach described above? Perhaps because one of the greats of the investing world mentioned it? The strategy was based on the assumption that an investor wouldn’t unnecessarily fiddle with it, apart from disciplined rebalancing. To be confident you won’t chop and change with a strategy, you need a deeper understanding of the inherent risks in it in the first place.
Right now it seems so easy. Since the 1970s though there have been four occasions that would seriously test the nerves of those with this approach. Bear markets in the mid-1970s, 2000 and 2008 produced slumps of around 40-50% in the major US share market indices. In 1987 the stock market crash saw the market fall by almost a quarter in one session.
Have you considered the appropriateness of a 90/10 stock/bond allocation for your own investing temperament?
Have you thought about whether having all your market exposure to a single country like the US makes sense? The US market is coming up as expensive on a variety of valuation metrics, significantly so when compared with the rest of the world. In a falling market you may have to read the news each day with all the financial experts in your head discussing the reasons why US shares are not the place to be. Can you remain loyal to your strategy in this environment?
ASX ETFs and the old low fee LICs
Do I just invest in AFIC or ARGO LICs?
For Australian investors, have you applied a similar strategy but to the ASX? Are you comfortable with more than a quarter of the portfolio concentrated in the four major banks? Renowned US value investor Bill Miller had a superb and consistent record of outperformance leading up to 2008, but when his sizeable bet on US financials came undone his reputation suffered. Already you must cope with many analysts suggesting the banking sector may be vulnerable to a slump in house prices and that the dividends may not be as reliable as many believe. There have also been many articles pointing out the large underperformance of the ASX this year compared to global markets. Can you hold your conviction that this strategy makes sense? If Australia ever has a recession again, can you stick to such an investing strategy when potentially it coincides with a bear market and you are reading about many Australians losing their jobs?
Ok then surely the answer is to diversify across other global markets I hear you say? Well then tell me which ones and what percentages! Are we now back to square one where you must come up with appropriate weights and now we need to make a complicated decision? I suppose we can choose a broad index like the MSCI World index. What happens then when you read about articles in the media pointing out some weaknesses with this index? Does it have too much exposure to developed economies facing headwinds from disappointing population growth such as in Europe and Japan? Does it make sense that China represents a large component of world growth but does not have an appropriately significant weighting in the index? Well maybe we can just apply our own little overweight there? Then you read an article about the debt build up within the Chinese economy and a crisis is looming, should I tinker with this China bet?
You could leave it up to a robo advisor, but without the in-depth knowledge of how they have worked out your allocations, will you keep the faith in the process if returns start to disappoint?
Oh, and I haven’t even begun to talk about the subject of currency exposure. Nor have I spoken about how often to rebalance, yearly or less often, or from a certain percentage deviation to targets? Then there is the question of which are the most efficient ETFs within certain categories.
The key takeaway I believe is to give plenty of thought to your own investing temperament and many other issues such as those described above. I am not bashing ETFs, because I think they are a fantastic development that are replacing a lot of the waste of fees that previously went to underperforming index hugging managers. I just think that there has been a few too many articles creating the impression that using them to meet your financial goals can be an extremely simple approach. i.e. requiring 10 minutes of reading time and copying an asset allocation you read from someone on the internet, or answering some very basic questions on your age and risk tolerance.
Sticking with a “simple” investing strategy can be an extremely difficult task. Do you meet many investors yourself that have applied a set strategy for more than a decade? It is human nature to want to tinker with things, and the set percentage allocations you decide on today may go against your changing beliefs in the future.
I think I counted 18 question marks in my article already, so does that reflect what some regard as a simple passive investing strategy? I am sure many readers of my blog think I try to over-complicate things with my ramblings, but just thinking about a passive investing approach is already even giving me headaches! It is something I can relate to, because I do have a gradual desire to tilt part of my investing to a slightly more hands off and uncomplicated approach over the next few years.
Maybe a solution is to simply buy Berkshire stock, but we also must be mindful that remaining loyal to an active manager can be even harder. Warren Buffett has had to remain convinced of his investing ability during some very large draw-downs and very long periods of under-performing the benchmark. Since 1980 we are talking of four occasions of losses in the order of 40 or 50%. This means approximately once every decade where his nerves are getting seriously tested, which may surprise some people to read. Then on various occasions many have questioned whether he can continue to outperform the index. A Barron’s article from December 1999 is famous for questioning whether Buffett had lost his touch, after a huge amount of under-performance during the tech boom. It is even somewhat ironic that in this latest bull market, Buffett’s performance doesn’t look that special when comparing to the 90/10 approach that I discussed earlier.
If you are thinking the share market since the last global recession has been an easy game of low fee market exposure then perhaps consider a quote I came across when watching a recent Ray Dalio interview, “If you don’t worry, you need to worry. If you worry, then you don’t need to worry”. Back in March 2009 there was a lot of worry, but investment returns since have showed there was no need to worry at that time. Things have changed quite a bit since then.
Finally, my sincerest apologies for those clicking on this article hoping to read about a simple investing strategy to apply, I have failed miserably on that front! Hopefully though some newer investors to the markets since 2008, may think a bit more deeply to the latest “simple” investing approach they have copied from someone off the internet. It then may give them the understanding, conviction and temperament to stick with a “simple” strategy and make it successful. I do believe if one gives plenty of thought to their investing strategy and is well prepared, they can succeed with a basic approach using low fee ETFs. I wouldn’t necessarily describe it as easy though, your conviction regarding your strategy is likely to be given a major test on many occasions.
P.S.
Here is one example of how it can be difficult to stick with the original investment strategy you develop. I don’t know how things turned out for this guy and I am not trying to criticise, I just found it interesting. The article appeared within the week of the US share market bottom in 2009.
I believe there are simple options readily available, e.g just pick a Vanguard Diversified fund that fits your risk tolerance (High Growth, Growth, Balanced, Conservative) and pour money into that regularly. It is identical to what most people do with their Super, just mirror the process outside Super and set and forget. Rebalancing is taken care of inside the fund. They are also much lower fees (assuming you qualify for the wholesale product) than robo-advisers if you don’t need the “advice”. More hands on investors will prefer to use ETF’s, manually re-balance, etc and this might shave a fraction off the fees. But for those who want hands-off and less behavioural risk, why not just pick an all-in-one diversified fund?
Hi Adrian,
Yes there are many diversified funds you can set and forget in and I agree with the point you make. I think many people handle this well in super because so many honestly do set and forget about super! My concern is outside of super many are likely to fiddle with this, and sometimes at at the wrong time.
My point is that if one doesn’t spend time doing some research and understanding what is within such a diversified fund, they may not stick with it over the journey.
The risk I see with this suggestion is as some investors glance over the various investment products performance this year, they may see that the diversified option is lagging some basic US equity ETFs, or global equity funds. Then they may read of some articles explaining this lacklustre performance because their diversified fund had too much ASX exposure, and not enough exposure to the great companies of the world. Facebook, Amazon, Google, Netflix, Tesla. I know quite a few people who like to complain about their investment product, and switch into something “better”. I know people who got fed up with their diversified returns in 2007 and switched to 100% equity, even within their super.
I have even seen some diversified products over the years change their allocations internally. eg having a meeting and deciding the product should have a larger weight now to whatever is hot.
If an investor doesn’t spend time developing an understanding in the first place they may be far more likely to tinker with it and chase performance by moving to another option.
What you suggest is likely to be perfectly fine, I just suggest at the same time for investors to think about what is in the diversified fund. Many have different views about what is the appropriate mix and you can still get quite a discrepancy of performance between diversified fund products. But if they understand what is in it in the first place there should be less chance of chopping and changing.
Steve.
Crikey Steve that’s a long one. There’s lots going on in that brain of yours nowadays. I just wish I had a brain that could think as well:-(.
Speaking of the Vanguard Diversified Funds they periodically change allocations / holdings. Recent changes dramatically altered the portfolio’s. Not sure I’d be happy with that. Likely big CGT event if unhappy with the changes and wanting to exit the fund.
Actually I’m tiring of the whole index / ETF thing lately. The contrarian in me doesn’t feel comfortable when something becomes a fad. I own VAS and VGS but only add to them when it makes sense to do so. After a crash or during a savage bear market is when it makes sense to me to increase exposure to index product. These holdings are quite small relative to other holdings in the portfolio. I haven’t added to VGS for quite sometime.
I’ve been increasing exposure to more active LICs including PIC / FGX / FGG rather than ETFs / older LICs.
Oops getting off topic sorry.
As for less experienced investors there are those who understand the behavioural aspects well such as Peter Bernstein who suggest that no new investor should commit too much to the sharemarket until they have experienced a major crash. Only then will they understand their risk tolerance and product / approach best suited to them.
Despite all the information available nowadays I think investing for most will be an incremental learning process unfortunately experiencing some painful lessons. The earlier in life these painful lessons are learnt the better as time is one’s most valuable asset. My investing journey when it comes to mistakes has been a shocker. But you learn from these mistakes and are better for it. The final outcome though has been very pleasing despite the hard school of knocks.
So yes in summary I agree, for most I don’t think there is a simple passive strategy especially in the earlier stages of ones investing journey. And by the time investors have figured out what’s right for them it’s likely they’ll never really be a truely passive investor because once an investor always an investor:-). But SIMPLE certainly is possible even if totally passive is more difficult!
Another day, another ramble. Actually after looking at your credentials recently I feel embarrassed to even be commenting here.
Please keep commenting Austing because you get to the point quicker than I do! Well summed up with your post there. Probably that Peter Bernstein reference itself largely covers what I wanted to get across.
For sure I totally agree simple strategies are certainly possible, it’s just that they probably have to come after plenty of time early on researching and a few battle scars from the market.
Your comments on some changes to Vanguard diversified products has made me curious, I’m interested to see what tweaks they made and why.
Bugger can’t find the damn article I wanted to show you but this thread from Whirlpool forums sums it up. In this instance the changes are potentially positive ones. But the fact that Vanguard can change the portfolio’s significantly at any time without considering the circumstances of the investor is not how I like to invest. I prefer a bit more control.
https://forums.whirlpool.net.au/archive/2628018
That’s interesting, it may well prove prudent but would have been better off if they implemented it before 2017.
I would hope it is a very rare change of this nature. If it is even a slight habit they may be a smaller step closer to tactical asset allocation. From what I’ve read that is tough to succeed at versus a strict rebalancing approach.
Yes I agree with your point too Steve. People still tinker with Super too. Discipline is always needed and overcoming the greed/fear/etc. that’s why I’d suggest for most people who want to get reasonable results without much effort take the low cost, diversified fund path. Stay away from online brokers, watch lists, etc. make contributions via BPay on the same day each month and be a price taker. Turn on the DRP if you don’t need the div’s. Switch off the financial news and keep reading those vanguard newsletters that will help you stay the course. I’m not sure about studying what’s inside the funds, maybe it helps or maybe it just leads you away from simple, hands off investing. The key realisation is that average returns are good and can be achieved with little effort. Most people who expend effort to outperform, ironically, end up doing worse. I doubt this approach would satisfy yourself, austing or me, but for those who are less interested and want to get on with other hobbies in life, i’d suggest it is a good way to go. Admin is pretty easy too if you just have the one fund.
Good suggestions there for many investors Adrian. It sounds easy and it should be, probably helps if you don’t find the markets interesting, a relatively disengaged approach like that will probably beat most out there! Perhaps the only research needed is to train yourself not to get greedy when you see your returns lag a bit compared to the aggressive products.
Just looking at Austing’s reply on this thread and even Vanguard can’t help themselves tinkering!
From memory Vanguard Global meet annually (or periodically?) to decide on appropriate asset allocation. It doesn’t always result in changes but it appears they are becoming more active in this area. One also loses control over CGT events when others are doing the rebalancing / messing with allocation. An accumulator investing in single asset class funds can maintain balance by simply directing new contributions to where it’s needed eliminating unnecessary CGT events. But again not entirely passive, a decision is required.
But for those with a tendency to tinker the above is less important than staying the course. Trouble is based on my very early experience when I had no interest in investing I still redeemed my funds for stupid reasons. It’s incorrect to assume that commencing a fund and setting up periodic BPay will solve investor behavioural issues regardless of whether they are interested in investing or not. I do believe it helps though. Certainly opening a trading account seems to open a Pandora’s box of negative behaviour issues for many investors.
Big day in the yard yesterday so sore body from work and sore head from enjoying too much beer to cool off at the end of the day. So hopefully post makes sense.
Yeah there are no silver bullets and as with anything in life people will have tendencies to self sabotage. However for those unable to follow a simple plan like the one I described, I wouldn’t be confident they could control their behaviour in a more active strategy either.
I’m not sure re: Vanguard’s adjustment to asset allocations in their diversified funds. I don’t use them myself because I’m more hands-on and do the ETF’s. But I would’ve thought they would be infrequent, and driven by structural market changes such as China being included in global indices, which require them to adjust to be consistent with their philosophy/mandate. That’s a very different form of tinkering than performance chasing, i.e. my mate was telling me his Super has gone up 50% because he’s all in emerging markets, I’m going to switch mine into that too.
Thanks for the discussion!
Good points Adrian. Regarding Vanguard I have only read briefly about the recent changes, Austing on this post thread may be more familiar.
From what I read I think you are correct and I won’t say they are performance chasing in this case. The changes seem to have occurred to remove some of the structural “home country biases” that exist for Australian investors. I have made similar arguments on the blog here.
It does raise the question though about whether performance chasing can be dressed up as “structural changes”. Were the home country bias issues they are addressing any more relevant today, compared with any time over the last 5 years?
I don’t want to come across as criticising them as I haven’t read enough of the changes, just raising the question that it could be a grey area. I am sure we could probably pick out a diversified product in the US in the early months of the year 2000, that held a meeting and concluded that structurally the world had changed and they needed exposure to the NASDAQ to keep up with the new economy. Then held another meeting a year later and concluded such exposure was too risky for their clients!
Yeah it might be a concern but at least in the case of vanguard there is not much vested interest given the Not For Profit structure. And while people seem to think index ETFs are a recent fad, the founder Jack Bogle (Buffett is one of his biggest fans) has been banging on about this stuff for decades. Have a google for his speech “investing with simplicity january 30, 1999” you will find key principles such as “stay the course”. The Vanguard philosophy is very clear and there are a bunch of devout followers (much more so than me, I invest in LICs too) who will pull them up if they stray much from it.
From memory the not for profit setup only applies to the US group not Aussie group. Happy to be corrected if wrong.
I personally own VAS / VGS.