Author Topic: Critiques of passive investing  (Read 3857 times)

NorCal

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Critiques of passive investing
« on: April 18, 2022, 01:37:07 PM »
The other thread about separating out active investing got me thinking about how little discussion there actually is about passive investing.  I figured I'd spark a discussion.

There's a lot of information out there that's being thrown around as gospel.  And while some of it isn't necessarily untrue, the efficient market hypothesis is now being claimed to say a lot of things that it doesn't actually say.

Here are the things that bother me most:

1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.

2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified."  This is sort of true, but not really.  As of today, Apple, Microsoft, Amazon, Alphabet, Tesla and Nvidia make up nearly 25% of the S&P 500.  Meanwhile, Real Estate makes up 2.4% of the index.  How is your investment really diversified if you're allocating 10x more to the big tech companies than you are to real estate? 

Cap weighted indexes are mathematically dominated by whatever sector is "hot" and highly valued.  While Cap-Weighted indexes certainly have their value and their place, unquestionably weighting your portfolio by market capitalization is likely not the best strategy.  It is intellectually lazy, and likely to lead to under-performance versus randomly picking stocks in different sectors and sizes.

3. While it is true that actively managed funds will underperform the broader market by the difference of management fees (on average, and on a risk-adjusted basis), there is no such penalty for individuals building their own portfolio.  Individuals only have the penalty of their own time, and might find good reasons to value the time they spend picking stocks.

4. There are a lot of places where the efficient market hypothesis is deliberately vague.  For example, the EMH deliberately doesn't define "The Market".  While the Boglehead guides took that to mean a cap-weighted S&P 500, the theory itself makes no such distinction.  The market can be defined in many different ways shapes and forms.  And this is okay, and perfectly aligned with EMH.  In fact, there's a reasonable assertion that the overall market would be more efficient if more funds used different measurements of the markets.

ChpBstrd

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Re: Critiques of passive investing
« Reply #1 on: April 18, 2022, 02:32:23 PM »
Regarding #1, I think earlyretirementnow.com and some of the discussions about portfoliocharts have sort of sucked the oxygen out of the asset allocation space because they're just so damn good and definitive. The historically correct answers are indisputable.

IIRC, Mr. Money Mustache himself did not see dwelling on AA or glidepaths to be particularly important things to talk about, because having an efficient lifestyle, a big savings rate, and a focus on boosting/diversifying income during the accumulation phase was more important - and most important was having fun, being there for your family, and being fit. MMM laughed in the face of corrections and recessions in multiple posts, seeing them as unworthy of the attention we give.

So on the one hand, we have well-documented answers, and on the other a perspective that they don't matter as much as we think they do.

Regarding #2, The definition of "diversification" is to have low-correlation assets so that rebalancing causes your portfolio returns to exceed the sum of its parts over time. When bonds started yielding next to nothing, when real estate appeared to be propped up by low borrowing costs, and when stock earnings yields dropped far below historical norms, then the value of diversification started to become questionable. Wouldn't rising rates wipe out everything in the everything bubble? That's when I started looking at options to protect my portfolio, rather than long-duration treasuries as was once suggested.

Regarding #4, EMH has been an intermittent punching bag here. However, it is intermittently applied and critiqued. Stock picking doesn't work because markets are efficient, but then EMH doesn't work because so many people are making so many sub-optimal choices.

In theory, meme stocks and crypto markets should be impossible, but here they are convincing presumably rational investors to allocate funds based not on the discounted value of expected future cash flows, but on celebrities' tweets and FOMO. There's also confusing stuff happening with negative real yields for treasuries, mature supply chains suddenly becoming inept, and the general fallout of helicopter money in 2020 and 2021.

But overall the reason EMH discussions run into trouble is as you suggested - most people haven't done the reading and so the concepts are muddled. There are very few, even among us, who have taken an economics class recently enough to explain why the ten-year treasury yield is used as a discount rate in NPV calculations for equity valuation, much less give an elevator speech on bond convexity, volatility smile, the mechanics of QE/QT, contango/backwardization, etc. Compared to most concepts in economics, EMH is easy to describe, but hard to quantify or quantitatively prove. It's borderline philosophy and temps people with partial information to dismiss it based on the impossibility of an outcome based on partial information. But then again, there is an unfalsifiability to it - where some missing information becomes the "god of the gaps". 

NorthernIkigai

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Re: Critiques of passive investing
« Reply #2 on: April 18, 2022, 02:41:25 PM »
I'll bite.

1. Risk tolerance is not at all about active or passive investing. Risk tolerance is about one's asset allocation, which for may mean "put everything in the market" for someone, but actually very rarely does. It's also made out of two parts: How much risk are you willing to tolerate, and how much can you tolerate? It's funny how often these two aren't the same at all: some people love to take risks but their situation doesn't really allow it, and many more could easily take a lot more risk but seem to think that investing is almost gambling.

Having established one's own preferred level of risk, considering both parts that go into it, whether one then invests actively, passively, in real estate, etc. is a completely different question.

2. This is always a funny one looking from outside the US. Yeah, I'm not going to invest only in the domestic stock market, since that would be betting on less than 1% of the market. I shouldn't laugh, because some people here do do this, probably because those companies feel somehow safer, since they've heard of them all, and also because (before cheap funds) investing abroad used to be costly and difficult. Still, no one's saying you shouldn't allocate some of your assets into, for example, small caps and real estate (at least I hope no one's saying that). That wouldn't be passive investing = following the market, but instead just lazy.

However, thinking that I shouldn't buy an index that has mostly hot stocks today because those same stocks may not be hot when I retire in X years is kind of beside the point. The index I buy today will per definition always have the hot stocks of the day in question!

3. The penalties of active investing include not just your own time, but also (usually, at least with the investing options I have here) higher fees, worse tax treatment, having to find those hot stocks (see above), and -- in my experience from working with investors -- most of all much higher trading frequency, leading to even more fees and taxes. It's hard to be an active stock picker without feeling the need to make changes to your portfolio all the time. (It's even harder if it is your job to actively manage a fund, then it's kind of what you, your employer, and your customers expect from you.) Stock picking is fun, I even indulge in it a little bit, but it makes sense to keep most of the stash in (several, geographically and sectorally diversified) passive funds/ETFs.

4. I've always understood the efficient market hypothesis as a framework, not an absolute truth. Sure there is sometimes a bargain to be a had or an arbitrage somewhere. The point is not that there isn't, but that these things are corrected on/by the market.

Car Jack

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Re: Critiques of passive investing
« Reply #3 on: April 18, 2022, 03:28:02 PM »
Quote
1. The most important investing decision is risk tolerance.
 

This is something that took some time for me.  The goal is to not panic and sell off when markets drop.  Remember the Fidelity study of its 401k account holders, where they found that the absolutely best returns were had by people with one definable characteristic.  They were dead.  I saw my in laws fall for the dropping market sell off.  MIL had a pension that was converted to a 401k and the garbage FA that the company had advising people seemed to be fine with 65 year old people buying 100% stock funds.  They sold off near the bottom of 2008.  Myself...I first followed the age in bonds and eventually stuck my numbers at 50/50.

Quote
2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified." 

 I also do believe what Jack Bogle said about why he didn't invest in international funds.  Why?  Ok....name a company that doesn't do business outside the US.  Go ahead.  Can't think of one?  Me either.  I've worked for lots of Semi companies,  some with names like "Texas" in them and guess where the majority of their business is?  It's not in the US.  So my thoughts are that the S&P 500 is chock full of companies who do international business.  On the other side, name a major company outside of the US that doesn't do business in the US?  Nope...I can't think of any.  So I did not sell off my international positions (VEA).  I froze them.  So I no longer buy VEA and when dividends come around, they buy VTI or the like.


Quote
3. While it is true that actively managed funds will underperform the broader market by the difference of management fees (on average, and on a risk-adjusted basis), there is no such penalty for individuals building their own portfolio.  Individuals only have the penalty of their own time, and might find good reasons to value the time they spend picking stocks.

I'll go back to Jack Bogle.  Looking to pick a needle in the haystack is really hard.  Those outperforming stocks are needles.  I just buy the haystack.  Most stock pickers spend a ton of time picking, buying, selling, timing.  I personally spent a couple years doing this really actively.  In the end, my 2 accounts that I did it with hit me at the same time.  One account had Polaroid and they went bankrupt.  Another had a small fab called IMP and the market got sick of them always needing money to stay propped up.  So in 2 years, I turned $4k into a $15 check that was lost in the mail.  I do have a very passive portfolio.  I buy and if my AA gets out by 5%, I rebalance.

Quote
4. There are a lot of places where the efficient market hypothesis is deliberately vague.  For example, the EMH deliberately doesn't define "The Market".  While the Boglehead guides took that to mean a cap-weighted S&P 500, the theory itself makes no such distinction.  The market can be defined in many different ways shapes and forms.  And this is okay, and perfectly aligned with EMH.  In fact, there's a reasonable assertion that the overall market would be more efficient if more funds used different measurements of the markets.

I don't really know what this means.  To take a guess, I call the S&P or total market funds stocks, ETF like BND bonds and I don't care about anything else.  I do still have VEA which is developed international, but I'm letting it dwindle as a % of my portfolio.  It actually has grown like crazy, more than doubling over the last few years, but see above why I don't consider international important.

MustacheAndaHalf

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Re: Critiques of passive investing
« Reply #4 on: April 18, 2022, 06:35:41 PM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


4. There are a lot of places where the efficient market hypothesis is deliberately vague.  For example, the EMH deliberately doesn't define "The Market".  While the Boglehead guides took that to mean a cap-weighted S&P 500, the theory itself makes no such distinction.  The market can be defined in many different ways shapes and forms.  And this is okay, and perfectly aligned with EMH.  In fact, there's a reasonable assertion that the overall market would be more efficient if more funds used different measurements of the markets.
In Feb 2020 on these forums, I posted a prediction that China would hit 10,000 cases several days later.  On schedule, CNN showed breaking news about 10,000 cases ... and the market dropped.  A small drop, but still: according to EMH, what I did is impossible.  The situation in China should have been priced in, but it wasn't.  I wonder how many people would do the same: If you could predict the future several days in advance, would you remain passively invested?  EMH is a theory, and my prediction in Feb 2020 falsified it for me.

I wouldn't recommend being an active investor to most people, and even then I'd suggest starting with index ETFs.  I had that foundation, and just happened to be perfectly positioned to watch the U.S. market miss the most significant event of 2020.

Villanelle

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Re: Critiques of passive investing
« Reply #5 on: April 18, 2022, 07:04:18 PM »
The other thread about separating out active investing got me thinking about how little discussion there actually is about passive investing.  I figured I'd spark a discussion.

There's a lot of information out there that's being thrown around as gospel.  And while some of it isn't necessarily untrue, the efficient market hypothesis is now being claimed to say a lot of things that it doesn't actually say.

Here are the things that bother me most:

1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.

2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified."  This is sort of true, but not really.  As of today, Apple, Microsoft, Amazon, Alphabet, Tesla and Nvidia make up nearly 25% of the S&P 500.  Meanwhile, Real Estate makes up 2.4% of the index.  How is your investment really diversified if you're allocating 10x more to the big tech companies than you are to real estate? 

Cap weighted indexes are mathematically dominated by whatever sector is "hot" and highly valued.  While Cap-Weighted indexes certainly have their value and their place, unquestionably weighting your portfolio by market capitalization is likely not the best strategy.  It is intellectually lazy, and likely to lead to under-performance versus randomly picking stocks in different sectors and sizes.

3. While it is true that actively managed funds will underperform the broader market by the difference of management fees (on average, and on a risk-adjusted basis), there is no such penalty for individuals building their own portfolio.  Individuals only have the penalty of their own time, and might find good reasons to value the time they spend picking stocks.

4. There are a lot of places where the efficient market hypothesis is deliberately vague.  For example, the EMH deliberately doesn't define "The Market".  While the Boglehead guides took that to mean a cap-weighted S&P 500, the theory itself makes no such distinction.  The market can be defined in many different ways shapes and forms.  And this is okay, and perfectly aligned with EMH.  In fact, there's a reasonable assertion that the overall market would be more efficient if more funds used different measurements of the markets.

2.  Many people own their home, investment properties, or both and often that equity is a significant part of their overall net worth.  So I think RE is a bad example.  I own a property (rental) and if anything that means I'm overly invested in RE, not under, given the value/equity in that property compared to my investments.

vand

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Re: Critiques of passive investing
« Reply #6 on: April 19, 2022, 03:11:08 AM »
Most people are reactionary about things that don't affect their everyday lives - markets, macro economics, geo politics, long term trends, large cycles etc - rather than follow the trends while they are on page 6 of the financial papers, they wait until they are on page one before deciding if they should meaninfully react.   Most people don't care to look at a company's financial statements or research it to understand its business model and what its relative strengths and weaknesses are. That doesn't mean they're not interest in money - who doesn't like money?

If this is you then that's absolutely fine - passive investing is absolutely the way to go. Adopt a long term strategy of tracker funds with a sensible asset allocation - and this is a more than good enough approach to become very very wealthly if you have a good saving rate and do it for a long enough time.

However, there are certainly those of us who are interested in these topics - when the Federal government starts sending checks out to all and sundry then we are looking forward to what that sort of profligacy sends us a year or 3 down the line.  While nobody can make good calls all the time, but it keeps our interest to educate ourselves and and at least have a level of understanding about these things.  To me, stuff like inflation is fascinating because at its core its about human beliefs and behaviour.

Investing in a personal undertaking - for those who aren't interested in the minutiae of the markets then passive indexing is absolutely in keeping with your interests and your personality. For those like me who are keenly interested in those matters then at least some level of "backing your mouth with your money" is also a consistent and understandable approach to investing.  Neither is "better" - just more or less suited to you as a person.


You don't need to have a 150 IQ to be a good investor.. but you don't have to leave your brain at the door, either.
« Last Edit: April 19, 2022, 03:13:22 AM by vand »

lifeanon269

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Re: Critiques of passive investing
« Reply #7 on: April 19, 2022, 06:12:20 AM »
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.

Absolutely that is risk. Just because you didn't know about its occurrence doesn't mean the risk wasn't there. Being oblivious to risk doesn't make it go away. The moment you invested you accepted and tolerated the risk that would come with it. Risk tolerance has nothing to do with what you do during a crash. Risk tolerance is simply aptly named. It is how much risk you're willing to tolerate when you decide to perform a given action. In investing's case, it is the risk you accept when you decide to make a given investment.

As another thought experiment, there is risk that comes with driving a car. The moment you step in your car and take it onto the road you are accepting the risk that comes with driving a car on the road. Just because you passed through an intersection where a car drove through a red light and narrowly missed you and you didn't even notice doesn't mean the risk there didn't exist. You're tolerating the risk that comes with driving a car regardless of whether or not you're constantly aware of potential dangerous situations or not. You don't need to be involved with a car accident in your lifetime to have varying degrees of risk tolerance with driving or to understand the risks involved with driving. Risk assessment can come from other people's experiences and using those experiences to better understand the risk for yourself. Maybe you decide to take a defensive driving course to help mitigate some of that risk as a compensating control.

With investing, maybe there is an investment you want to make, but it has too much risk for you, so as a compensating control you hedge a little bit so as to mitigate potential losses if things don't work out quite as you'd hope. Hedging will likely curtail some of your potential future gains, but because you're not willing to take as much risk, you're OK with that.

That's risk tolerance.
« Last Edit: April 19, 2022, 06:15:32 AM by lifeanon269 »

NorCal

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Re: Critiques of passive investing
« Reply #8 on: April 19, 2022, 07:01:11 AM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.

SparkyPeanut

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Re: Critiques of passive investing
« Reply #9 on: April 19, 2022, 08:03:22 AM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.

I agree - but putting money in a balanced portfolio now means around 40% bonds and they will just keep going down with all the rate hikes. What to do??!

EvenSteven

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Re: Critiques of passive investing
« Reply #10 on: April 19, 2022, 08:13:19 AM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.

I agree - but putting money in a balanced portfolio now means around 40% bonds and they will just keep going down with all the rate hikes. What to do??!


Well, the solution I have come up with is to make sure the duration of any bond funds I own is shorter than my investment timeline. That way, I don't have to worry too much about raising rates.

NorCal

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Re: Critiques of passive investing
« Reply #11 on: April 19, 2022, 08:23:56 AM »

Quote
2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified." 

 I also do believe what Jack Bogle said about why he didn't invest in international funds.  Why?  Ok....name a company that doesn't do business outside the US.  Go ahead.  Can't think of one?  Me either.  I've worked for lots of Semi companies,  some with names like "Texas" in them and guess where the majority of their business is?  It's not in the US.  So my thoughts are that the S&P 500 is chock full of companies who do international business.  On the other side, name a major company outside of the US that doesn't do business in the US?  Nope...I can't think of any.  So I did not sell off my international positions (VEA).  I froze them.  So I no longer buy VEA and when dividends come around, they buy VTI or the like.


This is one of those Bogle opinions that has aged poorly.  It was sort of applicable at the time, but also completely misses the point.

To put it simply, what is the point of diversification?  It has zero relation to where companies source their revenue.  It has everything to do with adding assets with low or negative correlations to your portfolio.

So the question is how correlated international stocks are to domestic stocks.  While you can weight this measurement many different ways over different time periods, the answer almost comes back as a positive but low correlation.  And this is exactly what most portfolios need!  So of course you should add international stocks.

When Bogle wrote his books, international stocks were very difficult to purchase and expensive to own.  I understand the cost to own international funds was several hundred basis points higher back in the 1980's.  So it was a reasonable conclusion back then.  The premium for owning international stocks today is a fraction of that.  So there is no longer a practical reason to be invested only domestically. 

Villanelle

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Re: Critiques of passive investing
« Reply #12 on: April 19, 2022, 10:49:32 AM »

Quote
2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified." 

 I also do believe what Jack Bogle said about why he didn't invest in international funds.  Why?  Ok....name a company that doesn't do business outside the US.  Go ahead.  Can't think of one?  Me either.  I've worked for lots of Semi companies,  some with names like "Texas" in them and guess where the majority of their business is?  It's not in the US.  So my thoughts are that the S&P 500 is chock full of companies who do international business.  On the other side, name a major company outside of the US that doesn't do business in the US?  Nope...I can't think of any.  So I did not sell off my international positions (VEA).  I froze them.  So I no longer buy VEA and when dividends come around, they buy VTI or the like.


This is one of those Bogle opinions that has aged poorly.  It was sort of applicable at the time, but also completely misses the point.

To put it simply, what is the point of diversification?  It has zero relation to where companies source their revenue.  It has everything to do with adding assets with low or negative correlations to your portfolio.

So the question is how correlated international stocks are to domestic stocks.  While you can weight this measurement many different ways over different time periods, the answer almost comes back as a positive but low correlation.  And this is exactly what most portfolios need!  So of course you should add international stocks.

When Bogle wrote his books, international stocks were very difficult to purchase and expensive to own.  I understand the cost to own international funds was several hundred basis points higher back in the 1980's.  So it was a reasonable conclusion back then.  The premium for owning international stocks today is a fraction of that.  So there is no longer a practical reason to be invested only domestically.

For me this is the primary argument for buying international.  It has very little to do with "international" and more to do with just "opening up the pool to own a bit of more things".   I don't even think that then having low or negative correlations is the primary draw (though it is nice).  To me, it's like saying that the main fund available skips every 10th company in the S&P500, but there's another fund you can buy that covers those every 10th funds.  More diversification is better.  If that also gets me something that is slightly less correlated to what I already own, even better. 

NorCal

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Re: Critiques of passive investing
« Reply #13 on: April 19, 2022, 12:15:35 PM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.

I agree - but putting money in a balanced portfolio now means around 40% bonds and they will just keep going down with all the rate hikes. What to do??!

According to EMH, the consensus view of rate hikes are already built into the price you're paying.  So you shouldn't worry about it too much. 

Also, as a wise man once said, "diversify your bonds, yo".  Different categories of bonds behave differently in an increasing rate environment.  High-Yield performs very different than Long-Term bonds, which may perform very different than international bonds.  Having a well diversified mix of fixed income makes a difference.

I'd argue that diversifying bonds is possibly more important than diversifying your stocks.  Your typical index stock funds will typically be highly concentrated in the big tech names, but at least they contain a broad array of stock types.

It's common for a "broad" bond fund to only contain bonds with a term shorter than three years from incredibly safe issuers.  A significant percentage of the bond market is completely excluded from the most commonly purchased bond funds.

Simply diversifying your equity holdings reduces risk as well.  Having international stocks or lower volatility equities makes a difference for overall portfolio volatility.

Scandium

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Re: Critiques of passive investing
« Reply #14 on: April 19, 2022, 12:21:53 PM »

1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.

Why? What is your "accepted wisdom" that this is so important based on? I never understood this. Just doesn't seem logical.
  • If the issues is someone will sell when they see stocks drop, then why not work on controlling that impulse, rather than rejiggering your whole portfolio to one less efficient! Never made sense to me. Cure the problem at it's root, don't just bandaid over it!
  • Even so, if one will "sell everything damnit!" with a 40% drop, who says they won't do exactly the same with a 20% drop? (that TV tells them will soon be a 40% drop anyway..) Seems like magical thinking that people will be wholly rational up to x% decline, but freak out at x+1%!

EvenSteven

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Re: Critiques of passive investing
« Reply #15 on: April 19, 2022, 01:11:57 PM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.


This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.

I agree - but putting money in a balanced portfolio now means around 40% bonds and they will just keep going down with all the rate hikes. What to do??!

According to EMH, the consensus view of rate hikes are already built into the price you're paying.  So you shouldn't worry about it too much. 

Also, as a wise man once said, "diversify your bonds, yo".  Different categories of bonds behave differently in an increasing rate environment.  High-Yield performs very different than Long-Term bonds, which may perform very different than international bonds.  Having a well diversified mix of fixed income makes a difference.

I'd argue that diversifying bonds is possibly more important than diversifying your stocks.  Your typical index stock funds will typically be highly concentrated in the big tech names, but at least they contain a broad array of stock types.

It's common for a "broad" bond fund to only contain bonds with a term shorter than three years from incredibly safe issuers.  A significant percentage of the bond market is completely excluded from the most commonly purchased bond funds.

Simply diversifying your equity holdings reduces risk as well.  Having international stocks or lower volatility equities makes a difference for overall portfolio volatility.

Lol! Also good advice from the same financial firm: Cream get the money, dollar dollar bills, y'all.

NorCal

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Re: Critiques of passive investing
« Reply #16 on: April 19, 2022, 01:52:52 PM »

1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.

Why? What is your "accepted wisdom" that this is so important based on? I never understood this. Just doesn't seem logical.
  • If the issues is someone will sell when they see stocks drop, then why not work on controlling that impulse, rather than rejiggering your whole portfolio to one less efficient! Never made sense to me. Cure the problem at it's root, don't just bandaid over it!
  • Even so, if one will "sell everything damnit!" with a 40% drop, who says they won't do exactly the same with a 20% drop? (that TV tells them will soon be a 40% drop anyway..) Seems like magical thinking that people will be wholly rational up to x% decline, but freak out at x+1%!

This goes back to finance theory, one or two layers behind the EMH headline statements.  This also goes back to my finance classes from over a decade ago, so I might be slightly mis-stating some details.

When digging into the theory pieces, think of it as you would the supply/demand curves in your economics class.  The theory holds and can be mathematically "proven", but it doesn't factor in psychological elements that can be discussed completed outside the context of the math.

When mathematically designing what we term an "efficient portfolio", we are looking to maximize the expected return for a given level of risk.  Risk is measured as the standard deviation of a portfolio.  This is a mathematical definition of risk that is likely different than you might think of it.

Mathematically modelling a portfolio requires three inputs for each asset you're looking to buy:
1. What is the standard deviation (risk) of this security? 
2. What is the expected return? Example: I expect this stock fund to return 7% and this bond fund to return 4%
3. What is the correlation of the price movements of each security?

Using this information, you can measure both the expected risk and expected return of any portfolio.  In fact, you could find portfolios with nearly identical risk/return profiles even though they have very different asset allocations.

So how do you choose which portfolio is right for any given investor?  You figure out their risk tolerance.  From this, you can back into an efficient portfolio.

I realize that I would have to write much more to adequately explain this, but hopefully this is at least a reasonable basis for understanding the statement.  For more reading, check out: https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/efficient-frontier/






Kem

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Re: Critiques of passive investing
« Reply #17 on: April 19, 2022, 04:16:10 PM »
Iíll partially bite and toss my 2c into this weighty diverse fray.

FI Pot 1 - Fully Passive (finished, 100% tax sheltered)
So long as the US is the location of the worldís most liquid and deep capital equity market pool with the top companies operating globally, the straight VTI path is sufficient (for me).  As such my Coast-FI pot is funded with 100% VTI.  This reaches 4% withdrawal at age 65 - assumes SS never pays.

FI Pot 2 - Nearly Passive (in progress, mixed tax structure)
Now that the Coast-FI pot is fully funded, Iím building an early FIRE pool to cover the world moved on scenarios at 36% VTI, 24% VXUS, and 40% non-traded REIT.  A comfortable withdrawal from this should cover 100% of living expenses within 8-10 years.   

FI Pot 3 - Active for a time (in progress, direct ownership with value adds)
Building business stakes with passthrough ownership rights that will survive my backing away from continued direct contributions of thought and analysis.  The distributions from this should cover 100% of living expenses within 5 years. 



Scandium

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Re: Critiques of passive investing
« Reply #18 on: April 19, 2022, 04:57:53 PM »



So how do you choose which portfolio is right for any given investor? You figure out their risk tolerance.  From this, you can back into an efficient portfolio.



But what does this mean? What is "risk tolerance"?
Is it based on an actual cash needs? I.e, something like: I can't have a >20% drop in my portfolio in the next 5 years, because I need the money? Vs somebody else saying I don't care, because I don't need it for 10+ years?

If so, great. That makes sense. It's an actual, quantifiable requirement. Cash needs (expressed as drop in portfolio value) vs timeframe

I just object to the more vague; "percent drop that makes me nervous, and I'd sell". That makes no sense, for the reasons I noted above. It's both illogical, impossible to quantify ahead of  time, and is better "cured" by learning to overcome the fear, not accepting illogical behavior! If someone is afraid of going outside, you talk to a therapist on how to overcome it, you don't stay in your house the rest of your life (at least that's not a very healthy way to deal with it)

Car Jack

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Re: Critiques of passive investing
« Reply #19 on: April 19, 2022, 05:25:10 PM »
Interesting discussion here about what diversity is and what it's for.  To me, diversification is having enough companies in one category that if one goes under, it isn't going to take my portfolio under.  I don't diversify to have counter direction companies.  Asset allocation with broad categories can do this.  Like having bonds that supposedly go up when stocks go down.  But I'm not buying Chevron and Tesla, figuring that when one goes up, the other goes down (although they're both in the S&P 500, so I guess I do buy them....just not for that reason). 

There are those who will absolutely set up their portfolio so that they have something that counters something else.  Stock and gold?  Sure.  But the downside is that gold just sits there and isn't a business making stuff at a profit and growing.  REITs are something that I guess might go a different direction than something else.  I never got into them as when I was researching, I found several funds calling themselves REITs that didn't own a square inch of real estate, but were chock full of credit default swaps.  I watched the Big Short, so have zero interest in these.


VanillaGorilla

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Re: Critiques of passive investing
« Reply #20 on: April 19, 2022, 07:26:57 PM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I think it's reasonably discussed, but I'm more interested in training myself to be risk tolerant enough to accept the performance of a mathematically optimal strategy, rather than trying to tune my investing to my emotional state.
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2. The common refrain of "I don't need to buy International/REIT's/etc because the S&P 500 is diversified."  This is sort of true, but not really.  As of today, Apple, Microsoft, Amazon, Alphabet, Tesla and Nvidia make up nearly 25% of the S&P 500.  Meanwhile, Real Estate makes up 2.4% of the index.  How is your investment really diversified if you're allocating 10x more to the big tech companies than you are to real estate? 
Why should real estate be weighted differently? The market cap is the cap. The historical performance is just that.
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Cap weighted indexes are mathematically dominated by whatever sector is "hot" and highly valued.  While Cap-Weighted indexes certainly have their value and their place, unquestionably weighting your portfolio by market capitalization is likely not the best strategy.  It is intellectually lazy, and likely to lead to under-performance versus randomly picking stocks in different sectors and sizes.
Randomly picking stocks will beat the index? No offense, but that's ridiculous.
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3. While it is true that actively managed funds will underperform the broader market by the difference of management fees (on average, and on a risk-adjusted basis), there is no such penalty for individuals building their own portfolio.  Individuals only have the penalty of their own time, and might find good reasons to value the time they spend picking stocks.
Sure, and plenty of people do. Plenty of rich people today bought tesla or bitcoin. Go for it.
Quote
4. There are a lot of places where the efficient market hypothesis is deliberately vague.  For example, the EMH deliberately doesn't define "The Market".  While the Boglehead guides took that to mean a cap-weighted S&P 500, the theory itself makes no such distinction.  The market can be defined in many different ways shapes and forms.  And this is okay, and perfectly aligned with EMH.  In fact, there's a reasonable assertion that the overall market would be more efficient if more funds used different measurements of the markets.
Nobody is keeping you from coming up with a better weighting than market cap. No shortage of funds either. Norcal Market Beating Fund, it'll be the next ARKK. (Being tongue in cheek here, just lighthearted fun. Nothing about Aldi or eggs intended.)

The nice thing about index funds is that they're large and diverse enough to say reasonably interesting statistical things about it. Historically the performance has been excellent - plenty to meet my goals. They're large and stable enough to believe that the future will likely be similar to the past.

Finally, investing just for accumulation is one thing. Investing for continuous drawdown is another, and only the very biggest investments have enough data to say anything with reasonably certainty. Invest purely in FAANG and a safe withdrawal rate is virtually impossible to analyze.

Or dump everything into Altria and spend a remarkable 26% SWR.

But for a nice middle ground of high expected return, reasonable volumes of historical data, and reasonably stable and predictable performance, a market cap weighted fund is hard to beat. In my humble opinion.

Philosophical arguments about internal diversification are pretty useless without data. International diversification has not improve safe withdrawal rates any time in the last hundred [edit!] fifty years. They offer excellent diversification when you don't need it, and very little when you do. Ergo, I don't hold any.

For posterity, I've got a house and a quarter worth of dollars in VTSAX and a (nearly) paid off house and a paycheck of cash. So my house is my implicit bond allocation. And my risk tolerance is...whatever that implies, 49 or so.
« Last Edit: April 19, 2022, 08:47:46 PM by VanillaGorilla »

maizefolk

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Re: Critiques of passive investing
« Reply #21 on: April 19, 2022, 08:29:57 PM »
International diversification has not improve safe withdrawal rates any time in the last hundred years. They offer excellent diversification when you don't need it, and very little when you do.

Do you happen to have a link for this? I know there are some good many-nations stock/bond datasets that go back more than 100 years, but as far as I know none of the datasets are publicly available, nor have I run across a study from someone who DOES have access to those datasets testing international diversification (rather than just comparing safe withdrawal rates within different individual countries).

Would be interested to read more.

VanillaGorilla

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Re: Critiques of passive investing
« Reply #22 on: April 19, 2022, 08:42:28 PM »
International diversification has not improve safe withdrawal rates any time in the last hundred years. They offer excellent diversification when you don't need it, and very little when you do.

Do you happen to have a link for this? I know there are some good many-nations stock/bond datasets that go back more than 100 years, but as far as I know none of the datasets are publicly available, nor have I run across a study from someone who DOES have access to those datasets testing international diversification (rather than just comparing safe withdrawal rates within different individual countries).

Would be interested to read more.
I was wrong, it's only over the last fifty (three) years!

There's an excellent essay on the subject here.

Also you can play around with portfoliovisualiser or portfoliocharts (which sadly only go back to 1972 and are thus useful but not conclusive. PortfolioCharts clearly demonstrates that Total Us Market has a higher SWR than any combination of Total US and Total World exUS, demonstrating that under the worst case scenarios international diversification offers no benefit (and in fact detriment). I'm not sure that PortfolioCharts includes 2000 or 2008 since those are less than 30 years ago, so it's pretty cherrypicked data. However, considering 2000 and 2008 individually is interesting.

For example, 100% total US market vs 60/40 US/exUS vs 80/20 US/exUS during 2008. The domestic portfolio fell the least and recovered the fastest by a large margin.

Of course in 2000 the international portfolio beat the domestic, but adding bonds would have been far more effective (a 60/40 portfolio ends at $800k at 4% withdrawal, the pure equity portfolios are around $400k, failing horribly).

Adding anticorrelated assets (bonds, gold) offers obvious improvements to withdrawal rates, but adding correlated assets obviously does little. The global equity markets are simply too correlated for international diversification to be interesting to me.
« Last Edit: April 19, 2022, 09:01:14 PM by VanillaGorilla »

NorCal

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Re: Critiques of passive investing
« Reply #23 on: April 19, 2022, 09:34:44 PM »

Nobody is keeping you from coming up with a better weighting than market cap. No shortage of funds either. Norcal Market Beating Fund, it'll be the next ARKK. (Being tongue in cheek here, just lighthearted fun. Nothing about Aldi or eggs intended.)


To be pedantic, Iím not talking about a market beating index, Iím talking about a better definition of the market.

Many of these already exist. Itís well acknowledged that equal weighted indexes outperform cap weighted indexes, but also have a bit higher volatility.  They just happen to be tax inefficient,  so youíd only want to hold them in a tax deferred account.

The DJIA predates the S&P 500, and happens to be price weighted, which is why no one takes it seriously.

I recently read that Schwab has some broad market funds that weight investments on fundamental factors like revenue and earnings growth. I really like this concept, but havenít dug into the details.

Iím really not trying to say cap weighting is the worst thing you can do. It works, itís simple, and itís tax efficient.  Iím just saying that itís an arbitrary methodology that is probably sub-optimal at the margins, while frequently being touted as the only way to index.  Iíd really just like to see more mental effort and discussion put into some of these things that are taken for granted.

BikeLover

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Re: Critiques of passive investing
« Reply #24 on: April 20, 2022, 01:03:45 AM »
International diversification has not improve safe withdrawal rates any time in the last hundred years. They offer excellent diversification when you don't need it, and very little when you do.

Do you happen to have a link for this? I know there are some good many-nations stock/bond datasets that go back more than 100 years, but as far as I know none of the datasets are publicly available, nor have I run across a study from someone who DOES have access to those datasets testing international diversification (rather than just comparing safe withdrawal rates within different individual countries).

Would be interested to read more.
I was wrong, it's only over the last fifty (three) years!

There's an excellent essay on the subject here.

Also you can play around with portfoliovisualiser or portfoliocharts (which sadly only go back to 1972 and are thus useful but not conclusive. PortfolioCharts clearly demonstrates that Total Us Market has a higher SWR than any combination of Total US and Total World exUS, demonstrating that under the worst case scenarios international diversification offers no benefit (and in fact detriment). I'm not sure that PortfolioCharts includes 2000 or 2008 since those are less than 30 years ago, so it's pretty cherrypicked data. However, considering 2000 and 2008 individually is interesting.

For example, 100% total US market vs 60/40 US/exUS vs 80/20 US/exUS during 2008. The domestic portfolio fell the least and recovered the fastest by a large margin.

Of course in 2000 the international portfolio beat the domestic, but adding bonds would have been far more effective (a 60/40 portfolio ends at $800k at 4% withdrawal, the pure equity portfolios are around $400k, failing horribly).

Adding anticorrelated assets (bonds, gold) offers obvious improvements to withdrawal rates, but adding correlated assets obviously does little. The global equity markets are simply too correlated for international diversification to be interesting to me.

On the assumption that the claim made here continues to be true, that the international markets drop with the US market, and drop more than the US market, a fairly obvious way to win would be to increase international (non-US) allocation more, the greater a drop in the US market from a previous peak, and decrease the international allocation as the market rises. Buy low and sell high.

But past performance is no guarantee of future results.

Look at it another way. Is investing in Germany alone, or adding an allocation of world markets, likely to lead to a higher return? France alone, or an allocation of world markets outside France? China alone, Or an allocation of world markets outside China? What's special about the US that has made it on average outperform world markets for the last decades, and what guarantee do we have that it will remain that way?

Tyler

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Re: Critiques of passive investing
« Reply #25 on: April 20, 2022, 02:03:22 PM »
PortfolioCharts clearly demonstrates that Total Us Market has a higher SWR than any combination of Total US and Total World exUS, demonstrating that under the worst case scenarios international diversification offers no benefit (and in fact detriment). I'm not sure that PortfolioCharts includes 2000 or 2008 since those are less than 30 years ago, so it's pretty cherrypicked data. However, considering 2000 and 2008 individually is interesting.

The SWR calculations actually do account for those more recent start dates and are able to project SWRs over longer timeframes based on how they naturally decay over time. You can read about how that works here.

MustacheAndaHalf

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Re: Critiques of passive investing
« Reply #26 on: April 21, 2022, 06:18:05 AM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.
This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.
By interning at a VC firm in 2007, I gather you didn't pursue it.  Vanguard Total Stock ETF (VTI) holds 4,000 stocks... none of them VC.  Being outside the public market, it's simply not captured in SPIVA data of active vs passive.  VC can beat the market without causing a ripple in EMH.

Thinking more, I'd say risk is money not being there when you need it.  It's a shortfall in the expected level of a nest egg.  Someone who ignores their portfolio, but then withdraws blindly, is taking risk.  I bring that up because if I'm willing to hold high beta stocks in a bull market, that only seems like a risk if I need the money during a bear market.  I suspect there's a disciplined way to hold volatile stocks or S&P 500 calls to enhance returns, while avoiding catastrophic results.

NorCal

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Re: Critiques of passive investing
« Reply #27 on: April 21, 2022, 07:04:16 AM »
1. The most important investing decision is risk tolerance.  How much risk should you actually take on?  The standard advice of "buy VTSAX" completely ignores risk tolerance.  You're taking the risk tolerance of the Market (beta = 1) and assuming that risk tolerance is appropriate for all investors.  This is turning the most important investing decision into a lazy and arbitrary non-decision.  Some people should be building portfolio's with a beta below 1, and others should be building portfolios with a beta greater than 1.  This is barely even discussed.
I like to question the conventional "risk tolerance" with a thought experiment: if an investor checks their quarterly account statements and nothing else, they only see their portfolio value on the statement.  If their investments lose money and then recover, where was the risk?  If they don't even see it, is that risk?

My current view is that risk tolerance is what you did in the largest crash of your time investing.  Someone who has not been through a crash has no idea of their risk tolerance - they've never been hit by losses of their money, to make it real.
This is a good way to think about it for most people.  My view is colored, as I first tried my hand at investing in early 2007 when I was interning at a venture fund.  I was just starting my Master's in finance.  This is before I had knowledge of EMH, indexing etc.  I was mostly going off stock-picks from VC's, which included buying shares in things like Chilean copper mines, back-end internet infrastructure, and aircraft leasing companies.  Let's just say that 2008 didn't work out well for me.  My risk tolerance wasn't nearly what I though it was.

This is why I give the general advice for investors that haven't been through a big crash to be more conservative than they think think they need to be.  It's also why I cringe when I see the advice to buy 100% equities.  That's just a recipe for bad decision making in the future.

The finance oriented view of risk (beta) is still a highly important part of a portfolio.  It's just less intuitive to your average investor.  This is a key input for assumptions around expected returns, drawdowns, withdrawal rates, etc.
By interning at a VC firm in 2007, I gather you didn't pursue it.  Vanguard Total Stock ETF (VTI) holds 4,000 stocks... none of them VC.  Being outside the public market, it's simply not captured in SPIVA data of active vs passive.  VC can beat the market without causing a ripple in EMH.

Thinking more, I'd say risk is money not being there when you need it.  It's a shortfall in the expected level of a nest egg.  Someone who ignores their portfolio, but then withdraws blindly, is taking risk.  I bring that up because if I'm willing to hold high beta stocks in a bull market, that only seems like a risk if I need the money during a bear market.  I suspect there's a disciplined way to hold volatile stocks or S&P 500 calls to enhance returns, while avoiding catastrophic results.

Interning in VC circa 2007 was interesting.  I had a full time offer to work at the firm, but that was contingent on them raising another fund.  2008 happened, and I ended up working for a struggling startup instead.

The numbers on Venture Capital are actually quite interesting.  Most Venture Funds don't perform as well as the S&P 500.  It's just that the few that perform well do REALLY well.  A typical fund will have about half of their companies go out of business.  Maybe 40% of the companies will break even or provide a small enough return to cover the losses from the bankruptcies.  Then you have 1-2 companies that make or break the fund.  The profile of these 1-2 investments really determines whether it's a mediocre fund or an amazing one. 

I'm still friends with the former Managing Director of the firm, and we talk investing a lot.  He's very much a Warren Buffet disciple, and he just retired from a full career in VC / Private Equity.  When looking back on his personal investing, he thinks he's maybe beaten the market by about 25 basis points over the long term, but done it by taking bigger risks.  He thinks his risk-adjusted returns are pretty comparable to index investing.  My counter is that his investing skills are what got him multiple jobs earning well in excess of $500K/yr.  So active investing earned him a lot, just not from being directly in the market.


VanillaGorilla

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Re: Critiques of passive investing
« Reply #28 on: April 21, 2022, 10:13:59 AM »

Interning in VC circa 2007 was interesting.  I had a full time offer to work at the firm, but that was contingent on them raising another fund.  2008 happened, and I ended up working for a struggling startup instead.

The numbers on Venture Capital are actually quite interesting.  Most Venture Funds don't perform as well as the S&P 500.  It's just that the few that perform well do REALLY well.  A typical fund will have about half of their companies go out of business.  Maybe 40% of the companies will break even or provide a small enough return to cover the losses from the bankruptcies.  Then you have 1-2 companies that make or break the fund.  The profile of these 1-2 investments really determines whether it's a mediocre fund or an amazing one. 

I'm still friends with the former Managing Director of the firm, and we talk investing a lot.  He's very much a Warren Buffet disciple, and he just retired from a full career in VC / Private Equity.  When looking back on his personal investing, he thinks he's maybe beaten the market by about 25 basis points over the long term, but done it by taking bigger risks.  He thinks his risk-adjusted returns are pretty comparable to index investing.  My counter is that his investing skills are what got him multiple jobs earning well in excess of $500K/yr.  So active investing earned him a lot, just not from being directly in the market.
That's an interesting perspective, thanks for sharing. I have some startup friends who deal with the VC capital acquisition process and I always wonder how much money the VC firms make (or lose).

The more I learn the more I appreciate the FIRE mantras of bare bones investing simplicity and focusing on savings rate and (secondarily) income.

ChpBstrd

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Re: Critiques of passive investing
« Reply #29 on: April 21, 2022, 10:42:09 AM »
Look at it another way. Is investing in Germany alone, or adding an allocation of world markets, likely to lead to a higher return? France alone, or an allocation of world markets outside France? China alone, Or an allocation of world markets outside China? What's special about the US that has made it on average outperform world markets for the last decades, and what guarantee do we have that it will remain that way?

In the event of a financial crisis, the U.S. has a track record of doing what other countries will not / cannot do:
1) Issue massive amounts of new currency and helicopter-drop the cash to consumers in a bid to restart stalled demand.
2) Facilitate the transfer of failing banks' assets to other firms in a bid to avoid contagion.
3) Make direct loans with preferential terms to key industries, as in 2009 and 2020-21.
4) Change laws and regulations in a bid to restart short-term economic growth.

Thus, the U.S. market is far safer than other markets, where recession interventions are not so dramatic.

Telecaster

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Re: Critiques of passive investing
« Reply #30 on: April 21, 2022, 12:53:49 PM »
There are two parallel discussions going on.  One is active investing.  Most people think of active investing as studying individual stocks or maybe sectors and moving money around based on whatever your analysis tells you.   The other is about portfolio construction.    How much international, small cap, etc. should be included in an ideal portfolio.

IMO, while managing a diverse portfolio of funds is a hair more active than just buying VTSAX, I personally don't think it qualifies as active investing.   One theory once you decide on the portfolio allocation, you simply rebalance every year or maybe not even that often.  I certainly agree portfolios can be optimized beyond just holding VTSAX and we've had tons of threads on that topic.   But again, I don't think that qualifies as active investing.  FWIW, I've mentioned equal weight from time to time and never had any push back.   You can certainly invest in equal weight indices passively. 

Re: Risk.   In the financial industry risk is usually defined as volatility.   However, I don't find that definition to be useful.  IMO a better definition of risk is "the chance of permanent loss of capital."   For example, let's say a 20 year old puts a lump sum into VTSAX and retires early at age 50.    The risk of losing money over that 30-year period is effectively zero.   Something catastrophic would have to happen to lose any money.    Volatility really only matters in the withdrawal phase and a few years prior, and maybe not even then.   The exception is if the individual has a low tolerance for volatility.   

Scandium

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Re: Critiques of passive investing
« Reply #31 on: April 21, 2022, 02:37:42 PM »
  Volatility really only matters in the withdrawal phase and a few years prior, and maybe not even then.   The exception is if the individual has a low tolerance for volatility.

Isn't this the same things then? One's "(lack of) tolerance for volatility" is only the inability to deal with a drop in portfolio value at a given time (i.e. when you need it?), or when you don't have sufficient timeframe to re-coup it. When you don't need the money you don't have low tolerance. That is the only consideration guiding risk.

Psychological considerations are not dealt with via portfolio design. It's both inefficient and ineffective. Worst of both!

clifp

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Re: Critiques of passive investing
« Reply #32 on: April 23, 2022, 03:40:33 PM »
There are two parallel discussions going on.  One is active investing.  Most people think of active investing as studying individual stocks or maybe sectors and moving money around based on whatever your analysis tells you.   The other is about portfolio construction.    How much international, small cap, etc. should be included in an ideal portfolio.
...

Re: Risk.   In the financial industry risk is usually defined as volatility.   However, I don't find that definition to be useful.  IMO a better definition of risk is "the chance of permanent loss of capital."   For example, let's say a 20 year old puts a lump sum into VTSAX and retires early at age 50.    The risk of losing money over that 30-year period is effectively zero.   Something catastrophic would have to happen to lose any money.    Volatility really only matters in the withdrawal phase and a few years prior, and maybe not even then.   The exception is if the individual has a low tolerance for volatility.

I picked an AA fairly early in my FIRE journey about 2022. I've been decreasing my bond AA since 2010 and now eliminated it.  My target international has been between 15-20% and it is been hard to maintain 15% It seems every year or two when I rebalance, I'm always moving money in my IRA from domestic stock to buying VEU, or the Schwab equivalent SCHF. My international funds have very modest gains and emerging markets are negative.

I'm cutting back my AA from 15-20% to 10-15%, but it is really tempting to adopt the John Bogle view and say I get adequate international exposure from US companies foreign sales.
The correlation between US and international stocks very high and according to Morningstar
https://www.morningstar.com/articles/1034112/does-international-stock-diversification-still-work

"Over the past 20 years, correlations for international stock markets have remained relatively stable, except for Latin America. That region's correlation with the U.S. equity market has trended down to 0.58 over the past five years, compared with as high as 0.80 in some previous periods."

With .90+ correlation for VEU or SCHF to VTI, I just don't see the benefit of including them in a portfolio, considering their consistent underperformance.



Looking at the big picture, when I started working in the tech industry in early 1980, there were many large and even dominant foreign tech companies Sony, Toshiba, Siemens, and SAP.  New Korean companies were growing, by the mid-1980 Japan dominated the semiconductor industry and consumer electronics. Even in early 2000, companies like Nokia, and Erickson were major players, in cellphones. Linux was up and coming in software, and ARM out of the UK was well-positioned.  Twenty, years later almost all of the European and Japanese tech companies are has-beens, South Korea has some great companies, but the tech giants are all either US or Chinese. The inability of Europe to create and nurture a tech giant is a source of major concern for Europe, but I see no sign that they have developed a solution.

As such, I see little true risk in many of the FAANG+Tesla stocks, by traditional measure volatility aka a stock beta FAANGT has considerably more risk than stocks, like IBM, Walmart, Wallgreens, Ford, Verizon, Chevron and other DOW stocks.  So it is entirely possible that FAANGT stocks either individually or collectively could drop by 50+% over the next year or two, but I don't see the first group dropping by that much.
But if you look at say 20 years from now, I wouldn't be surprised if almost all of the traditional companies disappeared, either bankrupt or acquired at pennies on the dollar. They all have a strong competitors as well as being subjected to technology disruptions Where as I'd be shocked if more than two FAANGT companies went out of business, who is going to develop an Apple ecosystem for device in the next 20 years, or display Google on search?  The market isn't being irrational valuing Tesla more than Ford, GM and Toyota combined.


expat

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Re: Critiques of passive investing
« Reply #33 on: April 24, 2022, 01:42:26 PM »
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.

NorCal

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Re: Critiques of passive investing
« Reply #34 on: April 25, 2022, 07:01:13 AM »
There are two parallel discussions going on.  One is active investing.  Most people think of active investing as studying individual stocks or maybe sectors and moving money around based on whatever your analysis tells you.   The other is about portfolio construction.    How much international, small cap, etc. should be included in an ideal portfolio.

IMO, while managing a diverse portfolio of funds is a hair more active than just buying VTSAX, I personally don't think it qualifies as active investing.   One theory once you decide on the portfolio allocation, you simply rebalance every year or maybe not even that often.  I certainly agree portfolios can be optimized beyond just holding VTSAX and we've had tons of threads on that topic.   But again, I don't think that qualifies as active investing.  FWIW, I've mentioned equal weight from time to time and never had any push back.   You can certainly invest in equal weight indices passively. 

Re: Risk.   In the financial industry risk is usually defined as volatility.   However, I don't find that definition to be useful.  IMO a better definition of risk is "the chance of permanent loss of capital."   For example, let's say a 20 year old puts a lump sum into VTSAX and retires early at age 50.    The risk of losing money over that 30-year period is effectively zero.   Something catastrophic would have to happen to lose any money.    Volatility really only matters in the withdrawal phase and a few years prior, and maybe not even then.   The exception is if the individual has a low tolerance for volatility.

The part on buying a diverse portfolio is spot on.  An incredibly important component of passive investing is asset allocation.  In fact, if you read the literature on the efficient market hypothesis, asset allocation is the key method in which risk is managed.  This is very different from active investing.

tamuaggie2011

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Re: Critiques of passive investing
« Reply #35 on: April 25, 2022, 07:29:51 AM »
Quote
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.

+1

For MOST of the population buying a couple index funds and just setting on autopilot is the best long term plan, BUT for people with interest AND discipline there are buying opportunities in individual stocks and you can still diversify.  Yes of course during a market crash you would also be "buying low" with an index but the real value during those times is finding the right companies that get way oversold.

One recent example for me: Covid crash happens and all oil companies get slaughtered well they aren't going away. I was able to pick up CVX with a div yield on cost of 8.4%. That position is only 3-4% of that stock portfolio but deals like that are the opportunities that greatly build wealth over time.

Scandium

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Re: Critiques of passive investing
« Reply #36 on: April 25, 2022, 01:03:21 PM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!
« Last Edit: April 25, 2022, 01:05:37 PM by Scandium »

EvenSteven

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Re: Critiques of passive investing
« Reply #37 on: April 25, 2022, 01:17:35 PM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!

  • Meta
  • Apple
  • Netflix
  • Amazon
  • Microsoft
  • Alphabet
  • Nvidia
  • Aramco

=MANAMANA, Do doo be-do-do

clifp

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Re: Critiques of passive investing
« Reply #38 on: April 29, 2022, 03:07:11 AM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!

I don't make up the acronym.  Right now top 5 is Apple,Microsoft, Amazon, Tesla, Alphabet, Meta (FB) is #11 and Netflix is  #92  and frankly should  have never been included. It is primarily a content company,not a tech company and never had wide moat.    AMATA works for me, and sounds like a Disney flick character name.  I definitely would include Microsoft, and my old company Intel #32 under new/old management may pull Microsoft and suddenly become relevant again. Unfortunately if Intel joins and Netflix disappears there is a surplus of vowels, not sure what to do about that.

Scandium

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Re: Critiques of passive investing
« Reply #39 on: April 29, 2022, 06:34:57 AM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!

I don't make up the acronym.  Right now top 5 is Apple,Microsoft, Amazon, Tesla, Alphabet, Meta (FB) is #11 and Netflix is  #92  and frankly should  have never been included. It is primarily a content company,not a tech company and never had wide moat.    AMATA works for me, and sounds like a Disney flick character name.  I definitely would include Microsoft, and my old company Intel #32 under new/old management may pull Microsoft and suddenly become relevant again. Unfortunately if Intel joins and Netflix disappears there is a surplus of vowels, not sure what to do about that.
Tesla isn't a tech company either, it's a car, and now battery, assembly company. (do they make their own now, or still get 18650 cells from others?). Regardless, industrial at best, not tech

MustacheAndaHalf

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Re: Critiques of passive investing
« Reply #40 on: April 29, 2022, 07:19:23 AM »
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.
Technically, it's cheaper to buy the 500 individual stocks in the S&P 500 for $0/trade than to pay even a 0.03% annual expense ratio.  But the problem, and my question to you, is the pain of dealing with 500 proxy votes a year.  How do you organize the annual report and proxy votes of 70 companies?

Fama was a co-creator of EMH, and later researched how value and small cap weight helped explain market returns.  But for many years he absolutely hated the momentum factor, despite it being stronger and more robust than small or value tilts.  Even the strongest, most revered proponents of EMH are capable of emotional bias.  Before turning active, I had switched from small/value indexing to tilting towards momentum.  It's an interesting blend of an active strategy with low costs.

Do you make use of any academic factors like small/value/momentum in your stock picking?  For example, do you screen for price/book or price/earnings?

ChpBstrd

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Re: Critiques of passive investing
« Reply #41 on: April 29, 2022, 08:01:33 AM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!

I don't make up the acronym.  Right now top 5 is Apple,Microsoft, Amazon, Tesla, Alphabet, Meta (FB) is #11 and Netflix is  #92  and frankly should  have never been included. It is primarily a content company,not a tech company and never had wide moat.    AMATA works for me, and sounds like a Disney flick character name.  I definitely would include Microsoft, and my old company Intel #32 under new/old management may pull Microsoft and suddenly become relevant again. Unfortunately if Intel joins and Netflix disappears there is a surplus of vowels, not sure what to do about that.
Tesla isn't a tech company either, it's a car, and now battery, assembly company. (do they make their own now, or still get 18650 cells from others?). Regardless, industrial at best, not tech

We have this concept that anything relating to information services or electronics is "technology sector" and anything related to logistics, manufacturing, construction, utilities, consumer products, business services, agriculture, etc. is "not technology". By this logic it is a technological advance if Amazon changes the layout of their checkout cart, using the same web standards that have been popular for 10 years, but it is not a technological advance if scientists develop a drought-resistant strain of wheat, if utilities discover grid designs that could reduce line losses, or if homebuilders start using 2x6 construction on 24" centers instead of 2x4 construction on 16" centers.

What's really weird is that pharmaceuticals are not considered "technology" despite the sector spending loads on money on R&D and being at the cutting edge of science. Eli Lilly - founded in 1876 - just announced stage 3 trial results of an anti-obsesity drug which caused participants to lose 20% of their body weight, and this comes less than a year after Novo Nordisk had a similar drug approved by the FDA. These improvements in medical technique promise to transform people's lives and yet we talk about Twitter and Apple as if an imperceptibly faster iPhone to scroll through dumb people's comments with a tiny bit less lag is a major change from how we lived a decade ago.

The word "technology" as an industrial adjective is aging like "modern" as an architectural adjective. A "tech" company can be little more than a website or an app like we've had for 15 years now, just as "modern" architecture was developed in the 1930s and reached its pinnacle in the 1960's - sixty years ago. How modern is a thing that's 60-90 years old? How cutting-edge is your average iPhone app? How does the marginal improvement of information services and electronic devices compare to much bolder transformations in how things are made, food is produced, money is transacted, roads are paved, or 1000 other things?

Growth potential? Netflix's subscriber curve just flattened, Amazon just reported a loss, everyone already has a smartphone, web commerce has been around since the late 90's, and social media is starting its third decade. Had you asked someone in 1970 what would be the technological growth industries of tomorrow, they would probably point to advances in jet engines, cars, and space travel, and they'd not even be aware of computing. The truth is, a 2022 model airliner looks and functions a lot like a 1970 model airliner, and all we've added in five decades are safety, efficiency, and luxury attributes. This is because technologies eventually reach mature and flat improvement trajectories.

What if the information age is nearing its end, and the new age will be in materials science, pharmaceuticals, gene therapy, energy, and/or physics - all areas where a few basic research breakthroughs could unlock vast potential just like the transistor did for the information age?

/soapbox 

Scandium

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Re: Critiques of passive investing
« Reply #42 on: April 29, 2022, 10:21:34 AM »
We have this concept that anything relating to information services or electronics is "technology sector" and anything related to logistics, manufacturing, construction, utilities, consumer products, business services, agriculture, etc. is "not technology". By this logic it is a technological advance if Amazon changes the layout of their checkout cart, using the same web standards that have been popular for 10 years, but it is not a technological advance if scientists develop a drought-resistant strain of wheat, if utilities discover grid designs that could reduce line losses, or if homebuilders start using 2x6 construction on 24" centers instead of 2x4 construction on 16" centers.

What's really weird is that pharmaceuticals are not considered "technology" despite the sector spending loads on money on R&D and being at the cutting edge of science. Eli Lilly - founded in 1876 - just announced stage 3 trial results of an anti-obsesity drug which caused participants to lose 20% of their body weight, and this comes less than a year after Novo Nordisk had a similar drug approved by the FDA. These improvements in medical technique promise to transform people's lives and yet we talk about Twitter and Apple as if an imperceptibly faster iPhone to scroll through dumb people's comments with a tiny bit less lag is a major change from how we lived a decade ago.

The word "technology" as an industrial adjective is aging like "modern" as an architectural adjective. A "tech" company can be little more than a website or an app like we've had for 15 years now, just as "modern" architecture was developed in the 1930s and reached its pinnacle in the 1960's - sixty years ago. How modern is a thing that's 60-90 years old? How cutting-edge is your average iPhone app? How does the marginal improvement of information services and electronic devices compare to much bolder transformations in how things are made, food is produced, money is transacted, roads are paved, or 1000 other things?

Growth potential? Netflix's subscriber curve just flattened, Amazon just reported a loss, everyone already has a smartphone, web commerce has been around since the late 90's, and social media is starting its third decade. Had you asked someone in 1970 what would be the technological growth industries of tomorrow, they would probably point to advances in jet engines, cars, and space travel, and they'd not even be aware of computing. The truth is, a 2022 model airliner looks and functions a lot like a 1970 model airliner, and all we've added in five decades are safety, efficiency, and luxury attributes. This is because technologies eventually reach mature and flat improvement trajectories.

What if the information age is nearing its end, and the new age will be in materials science, pharmaceuticals, gene therapy, energy, and/or physics - all areas where a few basic research breakthroughs could unlock vast potential just like the transistor did for the information age?

/soapbox

I agree with a lot of this, and you make some good points. Indeed "technology" is a pretty silly, meaningless term for a whole swath of industry, much of which is completely unrelated from one another. Yes everything uses technology, lol. Something like "information technology", and for some: "electronics" capture what they do better?

(thought again I'd argue Amazon isn't a tech firm either! It's a logistics/warehouse company, with a datacenter services grafter on, which is closer to a utility services these days.)

But I think you also attach an undue qualitative weight to the term. The stock market categories aren't saying anything about how important or meaningful these things are, it's just a way to (poorly) distinguish industries into groups. And I don't think it's meant to imply there is "zero technology" in the other categories!

Apparently there are 11 categories. And if this is to be believed Google and FB Meta are actually "communication services", not "technology". And since Entertainment is supposed to be there, Netflix definitely belongs to that group as well.
https://seekingalpha.com/article/4475586-stock-market-sectors

edit: this actually calls it "information technology" instead.
https://www.fool.com/investing/stock-market/market-sectors/
« Last Edit: April 29, 2022, 10:23:42 AM by Scandium »

NorCal

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Re: Critiques of passive investing
« Reply #43 on: April 29, 2022, 12:09:00 PM »
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.
Technically, it's cheaper to buy the 500 individual stocks in the S&P 500 for $0/trade than to pay even a 0.03% annual expense ratio.  But the problem, and my question to you, is the pain of dealing with 500 proxy votes a year.  How do you organize the annual report and proxy votes of 70 companies?

Do you make use of any academic factors like small/value/momentum in your stock picking?  For example, do you screen for price/book or price/earnings?

While it's easy to debate optimal investing strategy, simply buying all of the individual stocks in the index and holding them (with no adding or removing companies) is a guaranteed losing strategy.

I remember seeing a great presentation from a short-selling hedge fund manager back when I was getting my MBA.  This was 2007ish, so the numbers are a bit dated.  But he showed a chart of the S&P 500 since 1980, and it had returned some big number.  Maybe 300%ish.

Then he showed the chart of your investing performance if you had invested in the firms of the S&P 500 in 1980, but never added or removed companies.  This portfolio would have LOST over 50% in those 27 years.

My takeaway is that the process in which companies are added to or removed from an index is more important than the companies themselves.

Scandium

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Re: Critiques of passive investing
« Reply #44 on: April 29, 2022, 01:46:52 PM »
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.
Technically, it's cheaper to buy the 500 individual stocks in the S&P 500 for $0/trade than to pay even a 0.03% annual expense ratio.  But the problem, and my question to you, is the pain of dealing with 500 proxy votes a year.  How do you organize the annual report and proxy votes of 70 companies?

Do you make use of any academic factors like small/value/momentum in your stock picking?  For example, do you screen for price/book or price/earnings?

While it's easy to debate optimal investing strategy, simply buying all of the individual stocks in the index and holding them (with no adding or removing companies) is a guaranteed losing strategy.

I remember seeing a great presentation from a short-selling hedge fund manager back when I was getting my MBA.  This was 2007ish, so the numbers are a bit dated.  But he showed a chart of the S&P 500 since 1980, and it had returned some big number.  Maybe 300%ish.

Then he showed the chart of your investing performance if you had invested in the firms of the S&P 500 in 1980, but never added or removed companies.  This portfolio would have LOST over 50% in those 27 years.

My takeaway is that the process in which companies are added to or removed from an index is more important than the companies themselves.

nono, don't you see? You'll only buy the companies that are "cheap" and have "gone down" (and presumably will "go up"!). But you'll also "sell off positions if they go down" (sell low?), and "take profits" if they go up. Sell down! sell up!

How do you know which stocks are "cheap", and not on the way to "zero"..? By "reading"! You just need to find the right "writing" telling you which stocks will do well! But don't read the wrong thing, only the good stuff.. Nobody has thought of this, so it'll totally work out

GuitarStv

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Re: Critiques of passive investing
« Reply #45 on: April 29, 2022, 01:52:59 PM »
.... FAANG...

By the way, isn't this now:
  • Meta
  • Amazon
  • Apple
  • Netflix
  • Alphabet
= MAANA?

And Microsoft has a market cap higher than amazon or google, and 5 year growth not far behind apple, so why isn't that included?
edit; MSFT 5-year returns are also better than amazon, google, meta and netflix!

  • Meta
  • Apple
  • Netflix
  • Amazon
  • Microsoft
  • Alphabet
  • Nvidia
  • Aramco

=MANAMANA, Do doo be-do-do


MustacheAndaHalf

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Re: Critiques of passive investing
« Reply #46 on: April 29, 2022, 08:23:07 PM »
I am not convinced an S&P 500 index or some equivalent is superior for those who have an active interest in researching stocks and have an emotional temperament conducive to weathering a storm.

The crux of why low cost indexing is beneficial is the low fees and the buying and holding of equities. Inventors who build their own index say 50-100 stocks, may start to sell off positions if they go down or take profit on positions that have gone up.

Rich investors who use family offices or work with advisors don't buy an index themselves. They usually create their own one.

The appeal of this is you can opportunistically buy names that are cheap when they are down and you have more control over the type of stocks you want in your portfolio.

I have done this myself, basically 70 names diversified among various industries, and opportunistically buy cheap stocks I want when I have excess cash to deploy. It's not for everyone, but I prefer this approach. I also have an active interest in reading about stocks, so I am comfortable with what I own and can weather downturns in specific equities.

Maybe 5% of the overall population should take this approach, i.e. the types of people who like to spend their free time reading about companies and fund letters.
Technically, it's cheaper to buy the 500 individual stocks in the S&P 500 for $0/trade than to pay even a 0.03% annual expense ratio.  But the problem, and my question to you, is the pain of dealing with 500 proxy votes a year.  How do you organize the annual report and proxy votes of 70 companies?

Do you make use of any academic factors like small/value/momentum in your stock picking?  For example, do you screen for price/book or price/earnings?

While it's easy to debate optimal investing strategy, simply buying all of the individual stocks in the index and holding them (with no adding or removing companies) is a guaranteed losing strategy.

I remember seeing a great presentation from a short-selling hedge fund manager back when I was getting my MBA.  This was 2007ish, so the numbers are a bit dated.  But he showed a chart of the S&P 500 since 1980, and it had returned some big number.  Maybe 300%ish.

Then he showed the chart of your investing performance if you had invested in the firms of the S&P 500 in 1980, but never added or removed companies.  This portfolio would have LOST over 50% in those 27 years.

My takeaway is that the process in which companies are added to or removed from an index is more important than the companies themselves.
Do you know what everyone on Wall Street called indexing back in 1980?  Bogle's Folly, as a way to ridicule Vanguard founder Jack Bogle and his new S&P 500 index fund.  Nobody, this hedge fund manager included, was suggesting index funds 40 years ago.  Did you ask why they cherry picked a 27 year period, instead of 20 years or 30 years?  I think it's because 2000-2002 was terrible for stocks, with 2007 being subpar as the yield curve inverted.

Many studies have been done of randomly picked stocks, and they come to the opposite conclusion.  But then I've never heard of an investor who buys 500 stocks (even outside the S&P 500), and then does nothing for 27 years.  Are the dividends simply left idle for 27 years?  Also I'm not sure if your memory or the hedge fund manager was fooling you, but large cap investing from 1980 to 2007 returned over +2500%, not +300%.
https://www.portfoliovisualizer.com/backtest-asset-class-allocation

You left out a paragraph of my post, the first line of which is relevant here:
Quote
Fama was a co-creator of EMH, and later researched how value and small cap weight helped explain market returns.
I was interested in how someone picked stocks, which is closer to randomly picking than sticking to an index.  Acamdics studying stocks noticed smaller companies tended to have higher returns historically, so they needed a factor to capture it. People who pick stocks randomly tend to skew their portfolios towards small caps.  And small cap stocks, in turn, tend to beat the market in academic studies, which Fama & French would say is because the companies are riskier, and therefore must offer a higher return.  Over 1980-2007 small caps returned +3000%.  My quote mentioned "value and small" which together returned just under +6300% over that same time frame (again according to Portfolio Visualizer data).