A couple of weeks ago, Balance Junkie wrote a post called Why This Is No Market for Couch Potatoes. The main argument of the post—one that has been made many times before—is that passive investing is fine during bull markets, but it likely won’t work going forward because “we are in a secular bear market that began in 2000.”
This argument picks up on a previous post, where Balance Junkie referred to passive investors as ostriches who ignore macroeconomic conditions when they invest: “Sticking your fingers in your ears and singing while the markets tank is not a good investing strategy.”
This is a gross mischaracterization of passive investing, but I have to accept part of the blame. Balance Junkie referred to a recent column in MoneySense where I described the strategy as “the investing equivalent of flopping in front of the TV with a bag of Cheetos.” I realize now that there’s a problem with the terminology used by passive investors. Couch Potato, Sleepy, Lazy, Easy Chair, Gone Fishin’, Coffeehouse, Rip Van Winkle—if you miss the irony, it’s easy to infer that indexers have decided investing is just too much work, so they prefer not to think about it. They’d rather spend their time snoozing and just hope it all works out for the best.
So allow me to wipe the orange cheese powder from my lips, get up from the couch and explain why that’s never been true.
The lesson of history
One of the problems with passive investing, Balance Junkie says, is that a “reliance on broad-based historical data ignores the fact that markets experience both cyclical and secular trends over the long term.” Passive investors expect “annual returns of 6% to 8% like clockwork” and therefore the Global Couch Potato’s recent 10-year performance was “somewhat lower than advertised.” She also argues that the best data on past returns only go back to 1926, and “using an 85-year context for a 25-year investment time frame probably won’t be very effective.”
If any index investors are “advertising” absolute returns in the range of 6% to 8%, or expecting any returns “like clockwork,” I would be the first to call them out. Investing isn’t physics. You can say with certainty that the sun will always rise in east, and that a stock broker tossed from a window will always accelerate at 9.8 metres per second squared. But no one can claim that stocks will return 9% and bonds will get 5% over the next 25 years just because those are the historical averages.
But here’s the problem. Anyone with a financial plan has to make assumptions, and that includes expected rates of return. When you come up with these figures, you have two choices: you can look at the historical data, as imperfect as they may be, and use them to make reasonable estimates about asset returns. (If you’re sensible, your estimates will be less than the historical averages to build in a margin safety: most financial planners I know assume stocks will return about 7.5% or so.) Or you can dismiss all of the data as irrelevant, declare that everything is different now, and base your assumptions on economic forecasts. Which approach has the greatest likelihood of success?
The point is that passive investors do not ignore that markets experience cyclical and secular trends. They simply recognize that those trends can only be identified with hindsight, and therefore have no value when estimating expected asset returns.
What if we’re wrong?
Balance Junkie says that “passive investors are betting (yes, betting) that markets will be higher in the future.” I suppose we are. But over the last century, anyone with a horizon of 25 years would have won that bet 100% of the time. That century included global war, double-digit inflation, deflation, booming prosperity, recession and depression, currency devaluation, sovereign defaults, high interest rates, low interest rates, asset bubbles, terrorist attacks and disco. Yet over every rolling 25-year period the returns on a balanced portfolio would have held up well. That’s not a guarantee, but I like the odds.
Yes, but “passive investors are forgetting to ask themselves the question that is key to evaluating any decision: What if I’m wrong?” Are we really forgetting to consider this? If we assumed that past returns were guaranteed to continue in the future, we would put all of our money in small-cap value stocks, which have returned almost 14% since 1926. And no long-term investor would ever put a dime in fixed-income, because stocks have almost always outperformed bonds over long periods. The fact is, every prudent investor recognizes that even reasonable assumptions may not hold up—and so we diversify.
My own portfolio includes over 10,000 stocks, in more than 40 countries, in several currencies, as well as a significant allocation to real estate, nominal bonds and real-return bonds. The whole idea behind this kind of wide diversification is that any prediction I might make about the economy or the financial markets is almost guaranteed to be wrong.
Forecasts have no value
Balance Junkie suggests that passive investors should spend more time “learning about the stock market and the macroeconomic environment in which we live.” She argues that “it makes sense to adjust your asset allocation according to market and economic conditions.” Let’s set aside the fact that many advocates of passive investing are institutional investors, finance professors and economists. I’ll just respond with the same question she asked about expected returns: What if you’re wrong?
Everyone has an anecdote about the guru who predicted a market crash, or a bubble, or who made a good macro call. But the idea that investors can improve their long-term returns by adjusting their portfolios according to “changes in market structure, macroeconomic fundamentals, and technical cues” flies in the face of the evidence. Most forecasts about markets and the economy are wrong, period.
Rather than try to build this argument myself, I’ll turn things over to Larry Swedroe, who has made it eloquently many times on his blog—backed up with empirical data, as always:
How Much Value Do Economic Forecasts Hold?, April 29, 2009
Why You Should Listen to Economic Forecasts With Caution, August 19, 2009
Forecasting Should Be Left to the Astrologers, July 19, 2010
Don’t Listen to Economic Forecasters, November 24, 2010
How Are 2011’s Sure Things Faring at Mid-Year?, July 19, 2011
Why Basing Investments on Economic Conditions Is a Bad Strategy, July 22, 2011
Passive investing is not for people who are too lazy or dim-witted to understand how markets work, and Couch Potatoes are not Pollyannas who naively throw their money at past performance and expect absolute returns. They are investors who understand that in a world where we cannot predict the future, the most reasonable strategy is to determine the amount of risk you’re willing and able to take, diversify widely, keep costs low and tune out the noise. It’s not a perfect solution, but it has a far better track record than the fortune tellers.
Now pass the Cheetos, please.
What I always enjoy about your blog is how you can give a serious reply without taking yourself too seriously.
People seem to have a built-in strong feeling that if you work hard you’ll get results. Unfortunately for active investors, the expected results are negative. This doesn’t mean that the payoff will be too low compared to the effort; it means that the payoff is actually negative. The most likely result for an active investor is to lose the time spent working and lose money compared to a couch potato approach.
Bravo! Now that was a good morning read.
Funnily, I wrote about this topic today as well.
All this talk of market cycles reminds me of Harry Dent and Robert Prechter, who made a few correct calls in their time and it’s been downhill ever since. Anyone can spot a market cycle in hindsight. It’s much harder to do it in real-time.
“…and disco.” made me laugh out loud. Thanks for the response on behalf of Potatoes everywhere.
I’ve read a number of articles like that where the author looks at a fairly short specific time period (ie the US market from 2000 to 2010 which was flat excluding dividends) and concludes that because index investing didn’t do well in that one time period – it’s a not a good method.
Meanwhile, they don’t provide any kind of alternatives which presumeably would perform better.
Investing is all about probabilities and improving the odds in your favour as much as possible. Unfortunately, it’s likely not possible to have a 100% foolproof investing method. There are always going to be some uncertainties.
@Mike: Thanks for the comment. It’s interesting that you say “index investing didn’t do well in that one time period,” referring to 2001–10. I didn’t go into this in my post, but I should note that the whole point of the original MoneySense column was to point out that the simple Global Couch Potato outperformed 86% of comparable mutual funds over that period:
I may not have been thrilled with 4%, but until someone figures out how to make it rain during a drought, I’d say indexing is the best we can do.
@CCP – Yes, I agree that index investing did well during that period relative to most other equity investment funds.
I was more or less describing how Balance Junkie (and other bloggers) framed their argument. They usually look at the index returns in absolute terms (ie 4% doesn’t seem that great) and don’t compare to anything else. Or as Balance Junkie did – compared it against an inappropriate index (GIC ladder).
Here is a similar article written in 2008 by Jacob of ERE:
And of course my rebuttal… :)
I recall reading quite a few American articles on investing in 2009 and 2010 which lamented the zero equity growth of the American markets (excluding dividends) for the previous 10 years. However, the markets were at a bubble peak around 1999,2000 and of course any performance figures for a period starting at the peak will probably not look too good in absolute terms.
Interestingly, most of those articles didn’t crucify index investing, but rather investing in stocks in any form.
As you point out – regardless of what your investment method is, you have to be able to handle the bad times as well as the good if you want to invest in equities.
Pass the Cheetos!
This post is great! I love it :) I started to get hungry looking at the bag of Cheetos as well – btw I’d rather own the company and collect the dividends. Do index investors really eat this kind of junk food? I thought they were too smart for that.
I found the Balance Junkie post full of conjecture, and short on facts. And I don’t really see the alternative Balance Junkie is offering. The only thing I agree with Balance Junkie on is that 4% is a pretty low return.
Balance Junkie writes:
“The market is not my benchmark. My benchmark is zero.”
I rest my case.
The Dividend Ninja
I think that it is ironic that CCP says: “we cannot predict the future”, but then goes ahead and predicts it by saying that the future is rosier with passive index investing then anything else based on empirical evidence from the past! I think that CCP correctly indicates that one’s investment strategy must be based on determination of personal risk. I think that the risk of expecting the future to unfold like it has in the past is the major weakness of the couch potato passive investment strategy and requires incredible faith! When you are young this type of faith is easier but when you are older you will have found that evidence based research is only valid for today and may not hold for tomorrow which may unfold differently. Many of us believe that the market has changed significantly and that older studies looking at passive index investing may now no longer be valid going forward necessitating a valuation investing strategy.
@Ninja: You want to invest in Cheetos for the dividends? I thought you only bought blue chips, not orange ones. :)
The orange ones have a higher dividend yield with a low DPR! I’d stick with blue, but lets face it, its a completely different economy now. All the academic studies are worthless, they mean nothing now – since the market is suddenly different this time. Everyone is right. Stocks don’t go up and down anymore, bonds will provide you with nothing, and the global economy has been in a “Secular Cheetos Recession” since 2003 (That is why you should by Cheetos now).
Forget potatoes! I’m loading up on gold and actively managed mutual funds with MERs over 3% as we speak. After all these mutual fund managers really know what they are doing. All the fundamentals over the last 50 years are completely wrong, and stocks will never go up and down again. Everyone else is making 10% to 20% returns per year by embracing the new strategy- and you should too! (at least they say they are).
The only thing that is going to be worth any money at the end of the day are Cheetos. Sell all your potatoes now, wake up, and embrace the change of the new market according to everyone else! That’s right, greater than 0% returns gauranteed every year, but you’ll just have to have faith there really is a strategy :)
The Dividend Ninja
Speaking of chips, does anyone else remember Orange and Grape flavored chips back in the late 70’s? Hostess made them for a short time.
Love your reference to ‘disco’!
Nice response Dan. Your article made me hungry for chips and it was an interesting read at the same time. This is not an easy accomplishment, congrats of the double-win in my book.
I actually thought Balance Junkie’s article was good, I said so on her blog, but I thought that from the perspective of contexting; using historical references to help understand what has happened with the markets and what can be learned from them for the future. Beating up Global Couch Potato investors after our most recent 10-year investment window is a bit shortsighted but I didn’t see it as negatively as some others might have.
Part of my comment on her post was: “The timeframe is everything really; you can spin any data to meet your needs if you pick the appropriate investment window. I’m not saying you did this in your article, rather, I find many financial articles don’t take this bias into account. While I like your point about contexting, (85-year timeframe vs. 25-year timeframe), choosing an investment window to articulate portfolio returns is something writers need to take into consideration when discussing returns. Even avoiding a few high-return investment days on the market is enough to skew data.”
I’m a big fan of Couch Potato investing, in my RRSP in particular, and I don’t think it was her stance to mash potatoes so fiercely in the post but maybe I was wrong???
Maybe I missed her intent when she poked fun at the MoneySense article and the Cheetos reference. Passive investing was never meant to be easy but it certainly has less technical and emotional aspects associated with it than other forms of investing; such as dividend investing. I’m convinced Couch Potato investing works in the long-run because unlike other investing strategies, it is easier to stick with this plan to match the majority of investors’ objectives and maybe more importantly, it takes the mind-game away; temptations to chase hot mutual funds, stocks and other investments that let your emotions (and portfolio) run wild. Kinda like my brain on the topic of Scarlett Johansson. Geez, will my wife read this?
Anyhow, I doubt in my lifetime someone will figure it all out – nobody has any way of knowing “whether the next decade will see higher returns, but we do know that index investors are better equipped than ever to capture everything the markets have to offer.” Indeed.
Maybe a few of us need to write more “mashing the potato” blogposts? Your writing has some extra passion behind it when you have a rebuttal! ;)
@Mark: Thanks for the comment. I don’t think anything in Balance Junkie’s post was “beating up” on anyone. I didn’t take it personally. I just get frustrated when I hear the idea (often coming from financial advisors) that indexing is less sophisticated than active strategies.
As you recognize, the basis for passive investing is intellectually rigorous, and the data are robust. I’ve spent years studying it. Yet people persist in the ridiculous idea that it’s only appropriate for people who don’t understand how markets work, or aren’t willing to put in any effort. Right. People like Eugene Fama, Kenneth French, Paul Samuelson, William Sharpe, Burton Malkiel, Charley Ellis, William Bernstein and all the others who aren’t smart enough to do any better. Perhaps they’re too busy dusting the Nobel Prizes on their mantels.
At the same time, I acknowledge that those of us who write about the strategy unwittingly perpetuate that idea with our choice of language. I didn’t invent the term “Couch Potato,” but I’ve certainly milked it pretty good. :)
@Trollface: Orange and grape chips? Thank god I never encountered those. The worst one I remember was roast chicken flavor.
Though I do find indexing attractive, I tend to be of the referenced author’s opinion that ‘smart’ stock pickers will outperform. However, the difference is that I think spending time worrying about macro or economics or the like will tend to result in under-performing index investors (due to churn and fees) rather than over-performing.
Personally I think more people should focus on the parts of the market that are known to be inefficient if they want to earn better than average returns – micro-caps (<$25 million market cap) for example. An easy micro-cap strategy that has been proven to work over long periods of time net of fees is simply investing in a basket of stocks trading below NCAV and rolling them over once a year. Based on the experience of many value investors since the 1920's (see Graham's partnership for a notable example), just doing this has in the past resulted in a long-term return of over 15% per year, which is handily above the long-term equity market return.
While indexing is a good way to outperform mutual fund returns, I think other equally simple proven investing methods can easily increase the returns in the equity portion of a portfolio without taking on any more 'risk' than an equity mutual fund.
@Engineering Income: my curiosity has been aroused by your comments on investing in micro companies! Can you elaborate and tell us how this works? Any ETFs that track micro-company indices? Thanks..
Great article. John Bogle’s book ‘The little book of common sense investing’ has the MATH in plain english on 90 plus years of stock market performance to back up your article Dan. Bogle, a brilliant mathematician sets it forth in undeniable terms. In 2007 John predicted (along with a couple of high end investment buddies) a 6 to 6.6% investment return for the foreseeable future as probably being a ‘good’ return. To beat these numbers by 5 to 10 percent every year for 25 years or more would be the ultimate investment feat that very few would pull off. I would bet a case of Cheesies on that.
@EngineeringIncome and Be’en: Investing in micro-caps is actually how Dimensional Fund Advisors got their start (longtime readers will know I admire DFA). While it seems quite possible this market is inefficient, it is also illiquid, and DFA’s approach has long been to simply buy the asset class—which is essentially what they do with small-cap and value stocks as well. There is indeed reason to believe that these asset classes will outperform the broad market, but with correspondingly higher risk.
Be’en, there are some micro-cap ETFs, but make sure you understand the risks before investing in them:
@Superior John: Bogle’s “Little Book” was one of the first ones I read when I started learning about passive investing, and it’s the first one on my page of recommended books. It’s a great introduction to the basic ideas.
Bogle is not “a brilliant mathematician”. He is not a mathematician at all. He has an undergraduate degree in Economics from a time about twenty years before Economics became somewhat mathematically rigorous.
Bogle is a good salesman, and his contribution to increasing the popularity of indexing is undeniable. But he has always depended on others for analytical expertise, and he often makes statements that are inaccurate or incorrect in his own writings. To understand the theoretical case for indexing, he is not a very good source.
@John and Chris: Whatever Bogle’s academic background, his books have a deep wisdom that come from having spent a lifetime in the financial industry. Salesman? Maybe, but let’s agree that he could have made a hell of a lot more money if he had sold out his principles and become the head of any fund company other than Vanguard.
A great argument pro passive investing. Fact is as an investor as long as I do my best to keep the odds against me as low as they can be, I stand a good chance of making some money, whether I do it actively or passively makes no difference.