Don't pick the wrong lane

Many investors try and outperform, but often the best strategy is to take a passive approach.

Summary: Many investors try to outperform the market by switching asset allocations to get the fastest growth. However, even active professional investors pick the wrong investment lane more often than not, and just making a small timing mistake could be disastrous. If you are not concerned with outperforming, taking a passive whole of market investment approach and investing via index funds or ETFs will deliver returns.
Key take-out: Numerous studies support the theory that the majority of a portfolio’s returns variance is determined by asset class selection and only a small portion is determined by market timing and security selection.
Key beneficiaries: General investors. Category: Asset allocation.

Ever since Jack Bogle, the founder of Vanguard Investments and innovator of index funds launched the first index fund in 1976, investors have been entitled to the return of the investment or asset class they are investing in. However, in most cases, investors seeking to outperform the benchmark index often miss out on what they are entitled to.

The suite of index funds and more recently the advent of Exchange Traded Index Funds (ETFs) available across most asset classes provide a means by which, at relatively low cost, investors can consistently achieve the return of the asset class they want exposure to. Therefore investors, over the longer term, should not accept anything less than this benchmark as acceptable performance.

In this article, I am looking at the characteristics and merit of a ‘passive investment approach’.

Every major city has highways that are clogged around holiday times. And every city has drivers that constantly switch lanes as they move from a slower to a faster lane. Even though the lanes on the right tend to have the fastest flow on average, and the lanes on the left tend to have the slowest due to merging and exiting traffic, drivers often try to outsmart their fellow commuters. And yet, the new lane will often quickly become the slowest (while at the same time introducing risk to all on the road from those frequent lane switches). How many times have you seen that? In the end, there is no greater return for making the switch. If anything, time is usually lost and the frustration of a long drive increases.

This scenario is similar to what many long-term investors do with their investment portfolios. They tend to switch to what they see as the fast-moving lanes of the financial markets and away from what they perceive as the slow moving lanes. The problem, however, is they are often moving into what was fast by selecting investments after they have already risen considerably in price. And the investments they are moving away from tend to be those that have already fallen in price but are now on sale. In other words, investors are chasing performance by buying high and selling low.

In a contrast to active investment, passive investors subscribe to the theories that:

  • Capital markets work and are efficient – over the long run, the price of stocks and bonds reflect the true underlying value of those securities. As such, they do not seek to beat the market, but rather to ‘be’ the market;
  • Timing markets is difficult – while fear, greed and investor behaviour may drive market inefficiencies, taking advantage of such opportunities is difficult;
  • Diversification is essential – diversification is the antidote to uncertainty; concentrated investments add risk with no additional expected return; and
  • Structure explains performance – asset allocation principally determines results in a broadly diversified portfolio.

Costs are important – any outperformance achieved through active investment is often offset by higher management and transaction costs.

So let’s look briefly at a few of the foundations of a ‘passive investment’ theology.

Market timing

It’s very tempting to try to time the market, but very few people manage to profit from it consistently. Large gains can come in quick, unpredictable surges and missing only a small fraction of days – especially the best days – can defeat a timing strategy.

This chart sourced from Dimensional Fund Advisers shows that if an investor had invested $1,000 in the S&P/ASX 300 Accumulation Index in July 1992 and left it there for 21 years they would have had a balance of $6,706 by the end of June 2013. That represents an annualised compound return of 9.5%.

But if they had missed the best five trading days in that 21 year period, the balance would have been shaved back by over 23% to $5,134.

Missing the best 15 days or best 25 days – just a month in 21 years – would have made an even more substantial difference. Trying to forecast which days or weeks will yield good or bad returns is a guessing game that can prove costly for investors.

Stock picking

The active funds industry is based on the idea that stocks are not efficiently priced. Analysts search for undiscovered opportunities, ranging from the ‘value’ approach where one is essentially a bargain hunter, through to the ‘growth’ approach where one looks for companies with superior profit prospects.

Whether value or growth, or a combination, or something else entirely, active managers function on the basis that a skilled investor can identify superior opportunities and can outperform the market.

I am often asked about where I sit in arguments about market efficiency and whether stocks are correctly priced or not. This is very important. Why would one adopt a passive approach if there were all of those mispriced stocks out there, allowing skilled investors to outperform?

“The idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely.

Yet the market is full of people who think they can do it and full of other people who believe them …

Why do people believe they can do the impossible? And why do other people believe them?”

Daniel H Kahneman, 2003 Nobel Laureate In Economics

The reality is that the market is highly inefficient and skilled investors can outperform the market. However, that doesn’t mean everyone should invest actively and empirical data has shown that even the professionals struggle to outperform consistently.

Consider this study in 2006, which measured the percentage of accurate calls on the world’s 200 largest companies.

The study reviewed recommendations over a two-year period by 2,500 analysts from 350 stock broking firms. It was found that the best stock picking firm in the whole of the US was Merrill Lynch – but they only got it right 34% of the time! This tells us ‘the best’ got it wrong 66% of the time ... and as you can see it got a whole lot worse from there.
Graph for Don't pick the wrong lane

Asset Allocation

There have been many academic studies that support the theory that the majority of a portfolio’s returns variance is determined by asset class selection and only a small portion is determined by market timing and security selection.

The outcome of one such study of 91 large US pension plans over a 10-year period identified that security selection and market timing accounted for only 6% of portfolio returns. *

However, that’s not to say asset allocation is not employed in a well-diversified, actively managed investment portfolio.

For the 10 years to July 2013, the S&P/ASX300 has delivered an annualised return of 9.47%. This is the benchmark return every investor is entitled to. If you are not concerned with outperforming and are looking for a simple investment approach, then taking a passive whole of market investment approach and investing via index funds or ETFs will deliver this return.
Graph for Don't pick the wrong lane

However, even a passive investment strategy requires a disciplined approach taking into account one’s risk profile, investment objectives and applying regular rebalancing between asset classes to achieve the overall return you are entitled to. Investor behaviour, emotion and lack of discipline can have the same negative impact on a passive investment portfolio as may be the case in the active space. Any investor who pulled their capital out of their equity index fund at the bottom of the market during the GFC and failed to time their re-investment to catch the bounce back may well have underperformed many active managers.

*Source: Study of 91 large pension plans over 10 year period. Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, July-August 1986, pp. 39-44; and Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, “Revisiting Determinants of Portfolio Performance: An Update”, 1990, Working Paper.

Roger Wilson, Lead Partner, Lachlan Partners Wealth Management, Melbourne.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles