A few months ago I wrote about stress testing your mortgage ahead of higher interest rates. The threat has hardly abated, with the Financial Times noting that:
Borrowers now looking for another offer as their fixed period comes to an end will face much more expensive terms.
Average rates on a two-year fix have nearly doubled from 2.24 per cent a year ago to 4.24 per cent this week, according to finance website Moneyfacts.
The FTarticle (search result) adds that banks and building societies have pulled lots of mortgage products off the market, and they are being particularly quick to yank their most competitive mortgage deals.
The best table-topping rates might only be available for a few days before capacity is exhausted.
Hunting high and low
So far, so hairy.
Yet arguably we mortgage holders have never had it so good.
Because what would be spectacularly odd to any time traveler from the 1980s – who oddly chose to gawp at yield curves rather than, say, the iPhone – is the clear blue water between inflation and interest rates.
The UK CPI inflation figure favoured by the government and the ONS dipped unexpectedly this week. But it’s still at 9.9%.
The officially semi-defunct RPI figure that remains widely used in contracts is 12.3%.
Meanwhile the Bank of England’s Bank Rate is only 1.75%!
True, Bank Rate will surely be raised to 2.25% next week – it would already be there were it not for the period of national mourning – and given the state of core inflation I wouldn’t rule out a hike to 2.5%.
The pound falling adds even more pressure to raise rates. Sterling weakness makes imports (and commodities) even dearer – and we import a lot in Britain.
Yet even a 2.5% Bank Rate would be sat 8-10% below inflation, depending on how you measure the latter.
Whereas for most of my life – up until the financial crisis – interest rates ran well above inflation:
The Bank of England mandarins are of course familiar with this graph.
But from the start, this current inflationary episode has been seen as more a problem of supply than demand.
And despite a shocker in the US data this week, there are signs the inflationary impulses that set this ball rolling are, well, rolling over.
Inflation is still expected to fall back towards target by 2024.
The sun always shines on TV
As for demand, does anyone have a sense the UK economy is roaring?
Not me.
Perhaps the housing market has been running a bit hot. But aside from that it would be a watered-down punchbowl that the Bank of England would be taking away were it to get rate-rise happy.
Even an expansionary fiscal plan from the new UK chancellor in his Budget next week would only be giddying-up what seems like a pretty stagnant economy.
It’d probably add a smidge to long-term inflation expectations, because just like last week’s energy relief plan it will likely add to long-term borrowing.
But I don’t see the Budget setting off one of those Tory booms that gets named after the chancellor later when the blame is doled out. (Barber, Lawson…)
An end to conflict in Ukraine would fire up the old animal spirits. But that might equally reduce some of the global price pressures and supply chain issues that were already easing before Putin sent in his tanks.
(Of course I’d take it regardless of its impact on the price of eggs or mortgages).
Take on me
Odd as it seems then, I’d bet five-year fixed rate mortgages will peak at around 4% – at least for this cycle.
Even with inflation running at high teen double-digits for a short while.
In other words, it probably won’t get much worse from here, from a borrower’s point of view.
Of course your guess is (almost…) as good as mine. Events can do a number on economic expectations, anytime, anywhere.
What’s more the Bank of England’s commendably honest and downbeat talk has not been matched by as aggressive a campaign of rate rises as we’ve seen from some of its peers. Maybe the rate-setters will lose their nerve?
Time will tell, but for now inflation is fast paying off your mortgage in real terms.
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Time is something you can never have enough of when you’re compounding your way to financial freedom.
That’s because the big payoff from compound interest is back loaded.
In the early years, how much you can save from your income matters most.
But later on, your gains on money already socked away is usually what makes the biggest difference.
A return of say 10% on a near-retirement pot of £1,000,000 is an awful lot more than 10% on your first year’s savings of £5,000.
It’s £100,000 versus £500, to be precise about it.
Clearly the longer you can compound your money for, the better.
Unfortunately we can’t go back in time to begin earlier – the age-old lament of savers when compound interest first ‘clicks’ for them.
But in a novel post at On Dollars and Data, Nick Maggiulli suggests finding a few extra years further down the line as a way of boosting your returns:
How exactly?
According to the data, the answer is…exercise.
Exercising regularly to improve your strength and your cardiovascular health is the most effective way to increase how much time left you have on this Earth, all else equal.
I agree that personal fitness is an under-appreciated part of the game we’re all playing.
Few people would be happy to retire to fewer years than they might have enjoyed if they’d stayed in shape, or with not being able to do as much as they’d like due to physical limitations.
Not if they can help it, anyway. And Nick does his usual great job of marshaling the numbers to show that many of us can indeed help ourselves.
A solid exercise habit can be expected to add three to five years to your life, he finds.
Good, but even better getting fits means an additional six to eight years of your later years might be healthy – compared to if you’d done nothing.
Nick says:
You don’t need stress yourself out trying to save every penny. Instead, you exercise more, reduce your stress, and extend your life. This is a non-financial solution to a financial problem.
And while it might seem unorthodox, for those that are having trouble saving more, it might be the best option available.
Sooner than I’d like to think about, I’ll be 50-years-old.
Yikes. I was in my mid-30s when I wrote my first post on Monevator.
Unlike many people, I’ve always been very aware of the passing over time. This is not something that has snuck up on me.
I was barely 25 when the opening words of Kid Loco’s 1990s album A Grand Love Story smacked me between the ears:
“38 fucking years old…”
Only 13 years to go until I’d sound as broken as him!
Better get a move on.
Now here I am 25 years later and I’m not sure I really did.
But I can’t complain. Things have worked out okay.
Well, how did I get here?
Something that becomes apparent after you’ve lived for a few decades is that few of us methodically follow a plan to get where we want to go.
There’s no set directions. It’s not like a computer program. It’s barely like following the pictures in an IKEA leaflet.
Well, maybe some of the good bits are like the pictures. But not the rest.
This means that any life story – grand or otherwise – can only be told in retrospect.
Big picture, we never really know what’s going to happen.
The days go slow and the years go fast.
Still, we get on. We do things every day. And we don’t do other things that we said we were going to do.
It all accumulates. We shape our habits, consciously or otherwise, and afterwards they shape us.
These habits – reflexes, even – determine a lot of what we say, do, and achieve.
The work we put in. The breakfast we eat. How we sign off our emails. Whether we leave our friends happier than we found them.
The chances we turn down or back fearfully away from. Opportunities we seize too greedily. The ones we grasp just right.
Whether people think that we’re kind. Or greedy. Whether people forget us.
The stuff they talk about at funerals.
How do I work this?
Our lives are mostly our habits developed from birth and repeated for as long as we’re lucky to live for.
With interventions, of course. Whether from the outside world or – better – from within ourselves.
Your parents potty train you and stop you throwing your baby food on the floor.
You learn not to blurt out your feelings. If you’re lucky you develop a habit of reading books.
You take up weightlifting, or yoga. Try to make amends.
But there’s also a sort of entropy to habits. The ones we don’t care much about, or that we find too difficult – they fall into disrepair and disuse.
Your friendship circle shrinks because you didn’t pay attention. Your kids stop asking you questions after yet another brush off.
“Not now, I’m busy.”
If you wrote down the most important things in your life you’d say it was your family and friends.
But maybe your habits say otherwise.
Same as it ever was
Between the intentional habits we cultivate and the bad habits that find a home regardless, there’s always other habits coming into being.
Often they’re manifested by laziness – another birthright endowed to every one of us.
Nature is efficient, and seeks shortcuts. This shows up most obviously in your body.
If your arm is often reaching forward and your hand is usually sat upon a mouse, it’ll stop feeling awkward soon enough.
The weird posture will feel natural.
A child would fidget but an office worker might stay that way for hours.
Give it two decades and the cartilage in your arm adapts. Your shoulders are now permanently rolled forward. You’ve told your body to sit this way day after day, week after week. Your body listened.
Getting religion about stretching for a week every January won’t undo the damage.
One day you’re nearly 50 and people say you look good for your age but you know you’re an omni-shambles of impinged joints, slack abdominals, buggered knees, and eyestrain.
Some of this is inevitable. Ageing. But some of it you ordered up with your habitual choices, day after day.
You can try to undo it but it’s a slog. You’ll need to reprogram instructions hardwired by decades of repetition.
A lot of effort just to get back to the clean slate you began with.
Better to have had better habits. Better to have started fixing them years ago.
Otherwise better start now.
Am I right or am I wrong?
Money habits show up in our lives like the physical ones shape our bodies.
We start life without savings, debts, or much idea about what money is beyond the barter system.
Circumstances, upbringing, natural proclivities, and dumb luck begin to bring financial habits into our lives like freshly dug soil invites flowers and weeds.
Maybe as a kid you got a paper round. You were up every morning at 6am to earn a few quid each week. Perhaps the sheer heft of it made you value money. You saved most of what you earned. If you were really fortunate you saw it grow.
Your family was frugal and non-materialistic. They applauded your attitude.
40 years later and you’re writing a blog about investing. Financially free thanks to habits you barely knew you were cultivating.
Or maybe your family is very well-off. Your parents saw their parents strive and want to spare you the graft. You go to boarding school and are sent a generous allowance. It’s more than most of the other kids get – which makes you feel proud, so you show off – but it’s less than some – which makes you insecure.
40 years later you have a middle-sized house with a lot of front and a super-sized mortgage, three cars, and a spendthrift spouse. And no savings.
My god, what have I done?
Too convenient? Absolutely.
You grow up in a frugal, non-materialistic household. Get a paper round. Hoard your pennies. Truth be told you’re a bit of a tightwad. You equate work with money, and subconsciously think of net worth as self-worth. You save everything and scrounge pints off your friends. You have a boring job in a sector you don’t care much for because it pays well and there’s a solid pension plan.
40 years later you’re still renting because houses always look too expensive. You never married because you fear a costly divorce. You’re constantly frightened of losing your savings to a bear market and so you keep 80% of your money in cash.
Or… your family is rich. Your parents tell you there’s more to life than money. They saw their parents ground down by scrimping and saving. They send you a generous allowance while you’re away at school but they encourage you to invest half of it in the stock market. “Money is the key to making money” they tell you.
You watch them sell their small family business and re-invest the proceeds into property and shares. They’ve never been richer.
40 years later and you’re on your second start-up, having sold the first for a few million. It was touch-and-go, but your team never saw you wobble. Nor does your partner who loves your generosity of spirit as much as your financial firepower.
That said, your daughter reads a lot of FIRE1 blogs and tuts when you buy a holiday home in Ibiza…
Letting the days go by
There are a lot of ways to get from A to B in the game of life.
Quick. Roundabout. Some downright deadly.
We’re not all offered the same routes. But one thing we can all try to do is to cultivate the habits we want to take with us on the journey.
These habits will make us the people we want to be – or not. Regardless of whether we ever get to our destination.
If you want to be solvent, start saving any small amount of money. Develop the habit. Go from there.
Blowing the budget is your big bugbear? Start by thinking about the cost of every single little thing you buy.
You’re wary of risks and the stock market terrifies you. Don’t put 90% of your money into shares just because you read that’s appropriate for your age. Put in 10% and develop a feel for the market’s ups and downs. Find your sea legs. You can invest more when you forget why you were so frightened.
Worried you’re too stingy? Your shoulders are hunching and your arms are stuffed in your pockets. Your back is up, and turned away from your mates. Surprise everyone by paying for dinner. Tell them you got a bonus at work. Or your premium bonds came in. Who cares, brush it off. Or give £20 to the homeless guy outside M&S who – yes – looks like he could get a job. Or buy him lunch and give it to him on the way out.
Start somewhere. Change direction.
You won’t remember most of what you do out of habit. But they will be the ‘reps’ that build your financial posture, just as bicep curls give you guns.
It takes time.
Then one day someone will say you’re good with money. Ask your advice about investing. Buy you dinner as a thank you for something you didn’t even notice you did for them.
Because you did it out of habit.
Once in a lifetime
Sure you’ll remember the make-or-break moments when you look back on life.
That time you said yes to the weird person asking for your number. You married them! The job you agonized about leaving, only to land the opportunity of your dreams. Your first night in your first own home. Your baby smiling up at you. Antarctica. A lottery win.
But these are near-random escapades on a long road where mostly nothing much different happens.
Just maybe your good habits put you in the right place at the right time. But most of life is simply getting up every day and walking.
Why not stand tall, practically and metaphorically? Don’t shuffle and look at your feet and complain when you’re old that you can’t turn your neck.
Don’t do the wrong thing every day and wonder where your life took a wrong turn.
Try to do lots of little things right. Whatever right means for you.
We might as well be upfront: the passive vs active investing debate isn’t much of an argument. On one side is a mountain of evidence in favour of passive investing. While on the active investing side is a mountain of marketing money attempting to keep a very profitable show on the road.
It’s a story not unlike that of the tobacco or oil industries facing down their own inconvenient truths. Where the corporate incumbents deploy cash like nails under the wheels of progress. Slowing down change for as long as possible by befuddling consumers in a fog of doubt and alternative facts.
That said, what is the case for passive investing?
In a nutshell:
Active investing returns aren’t consistently good enough to overcome their higher costs. Over a lifetime, this means that passive investors will earn higher investing returns than active investors, on average.
Below we’ll walk through the key passive vs active investing evidence that justifies this conclusion.
What is passive vs active investing?
Passive investors hold entire markets, such as global equities or UK government bonds. The evidence suggests this low-cost, low-turnover diversification across key asset classes is a winning investment strategy for most people.
Each such market is defined by a benchmark index such as the MSCI World, S&P 500, or FTSE All-Share.
Passive investments such as ETFs or index funds replicate those indexes very efficiently. In doing so they enable investors to hold a whole market like UK equities in a single vehicle.
This makes index trackers the ideal way to implement a passive investing strategy.
Active investors, by contrast, hold a particular subset of each market they care about. They (or their fund managers) pick the mix of funds, individual shares, or other securities that they believe will do better than the rest. (“Outperform,” or “beat the market,” in the jargon.)
Active investors may also time their trades – trying to stay ahead of current events like surfers riding a powerful wave.
But active investors can be dragged down by their efforts to beat the market. They may misread events, choose the wrong securities, or incur such high costs that they earn worse returns than if they’d just taken the market average.
Passive investors, meanwhile, accept they do not have the skill to beat the market. They therefore choose low cost index trackers that reliably deliver the average market return, minus the wafer-thin fees necessary to run these funds.
By investing enough money, into the right combination of assets, for enough time, passive investors aim to achieve their financial objectives by earning the market return.
Thus active vs passive investing is the financial version of the tortoise vs the hare. Slow and steady wins the race.
Passive vs active investing evidence
The reason why passive investing is better than active investing largely boils down to costs.
Nobel Prize winner William Sharpe laid out the mathematical reasons why passive funds prevail.
When you look at the total population of investors:
Passive investing delivers average returns minus low costs
Active investing delivers average returnsminushigher costs
The lower your costs, the more of your money you keep. The higher your costs, the more your money is diverted to some Ferrari-driving fund manager.
Passive investors beat active investors as a group because both earn the same returns on average – but passive investing costs are lower. (See the Financial Conduct Authority evidence on the damage wrought by fees below.)
Sharpe showed that the total market return is the sum of all investors’ returns. By definition, the market must encompass all investors who outperform and those who underperform:
That sum of outperforming and underperforming active investors is the reason why active investing is a zero-sum game.
The winning investors earn their gains at the expense of the losers.
But passive funds stand aside from this ferocious competition. Index funds and ETFs are designed to capture the return of their market. They do this reliably because they own that entire market. They don’t seek to profit from owning a particular slice in the hope of outperforming.
As a passive fund investor this means you can count on achieving the average market return – less the slim costs needed to run the fund.
Active investors as a group are similarly left with the same average market return. But crucially they must then deduct higher costs.
Hence the passive v active investing debate ends in a win – on average – for passive investors.
Passive vs active investing as explained by Warren Buffett
A lot of very smart people set out to do better than average in securities markets. Call them active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.
Therefore, the balance of the universe – the active investors – must do about average as well.
However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
Active investors are betting that they can find a combination of securities that enable them to consistently beat the market.
They believe they will rank in the set of winners who achieve higher than average returns.
They do not believe they will fall into the set of losers who inevitably weigh down the results of active investors overall.
If they thought they were doomed to underperform then they’d buy passive funds and accept average returns.
Some people are fooling themselves. All active investors must believe they’re above average. But we know it’s impossible for everyone to be above average.
In fact the evidence shows the majority of active investors overestimate their chances of beating the market.
Active vs passive investing: why amateurs get fleeced
The competition between professional active investors is fierce. The stakes are sky-high: if you can consistently beat the market then you’ll rake in fabulous wealth.
Ordinary investors try their luck, too. Picking stocks on trading apps. Perhaps investing in an industry of the future like AI, robotics, or healthcare.
But remember active investing is a zero-sum game. Winners pick the pockets of losers.
And ordinary investors don’t realise that most of the time they’re competing against huge financial players. They’re kitted out like Mr Blobby on a battlefield stalked by giant terminator droids who use amateurs for target practice.
Civvie active investors pit their stock tips and hunches against smart-money war machines deploying ranks of quantum physics PhD.s, advanced AI, data connections powered by lasers, terabytes of industry intelligence, and a relentless 24/7 work ethic.
Some active firms have literally dug through mountains for an extra millisecond trading advantage.
David Swensen, the famed manager of Yale University’s endowment fund, candidly assessed the chances of ordinary investors in his book Unconventional Success:
Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon.
There’s a reason the finance industry calls regular folk ‘dumb money’.
Learn what to do if you’re an ordinary investor with no reason to believe you can beat the smart money.
Active vs passive funds: why picking a professional is a losing game
An alternative active approach is to outsource your strategy to someone who promises to smash the market for you.
Intuitively it seems obvious. Find someone with a good track record, and let them spin your mini-bucks into megabucks.
Sadly, this doesn’t work either. The long-running SPIVA study shows even most investment industry professionals can’t outperform for long.
A whopping 62% of active fund managers investing in UK equities failed to beat the market over the ten years prior to the end of 2021.
It gets worse.
90% actively investing in global equities failed to beat the market across the same decade.
95% of actively managed equities funds investing in the US failed too.
Some managers do buck the trend for a while. And a few maintain their winning streak for years. They’re hyped like the Second Coming by a finance industry eager for miracle workers.
But like aging prize fighters, most are brought down eventually. Neil Woodford being the most spectacular crash and burn in recent UK investing history.
The evidence against persistent active manager outperformance led the FCA to conclude:
It is widely accepted that past performance is not a good guide to future performance. We find that it is difficult for investors to identify outperforming funds. This is in part because it is often difficult for investors to interpret and compare past performance information.
Even if investors are able to identify funds that have performed well in the past, this past performance is not likely to be a good indicator of future performance.
Picking an active fund on the basis of dazzling recent results is like handing your money to someone who just hit the jackpot on a fruit machine. There’s no guarantee they can repeat the performance. There’s many reasons to think they won’t.
They don’t make their money by beating the market
Failure isn’t worth the risk when your financial future is on the line and that’s why we recommend using a passive investing strategy.
This is difficult to credit in the face of active investing propaganda – and even common sense.
So let’s turn again to Warren Buffett, the Sage of Omaha, for a dose of his condensed wisdom:
Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.
A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.
There are a few investment managers, of course, who are very good – though in the short-run, it’s difficult to determine whether a great record is due to luck or talent.
Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.
The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.
Remember we’re not saying that active investors can’t beat the market full-stop. Some do.
But active investing is like a sea seething with mosasaurs and megalodons. People get eaten for lunch all the time. And it’s rare for even the biggest of beasts to stay on top for long because this is an ultra-Darwinian competition, red in tooth and claw.
Knowing this, the finance industry long ago realised it’s easier to profit from high fees and the human desire to believe we deserve better than average.
A UK academic study by Blake et al points to the true beneficiaries of active management:
Although a small group of ‘star’ fund managers appear to have sufficient skills to generate superior gross performance (in excess of operating and trading costs), they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors.
Passive vs active investments: the importance of costs
An FCA report on the UK asset management industry confirmed the passive vs active fund findings of academics like Sharpe and investing insiders like Buffett:
Active funds for sale in the UK, on average, outperformed benchmarks before charges were deducted, but underperformed benchmarks after charges on an annualised basis by around 60 basis points.
Now, that cost gap doesn’t sound so bad. Which helps explain why many people risk taking the active side of the passive vs active investment bet.
But the FCA produced this chart to show how much wealth active management can leech during quite a short investing lifetime:
The graphic compares the ultimate returns (after costs) to an investor in typical UK funds:
Passive investing returns (red line)
Active investing returns (blue line)
The passive investor’s returns are 44% higher than the active investor’s.
It’s a tiny discrepancy at first. But the higher fees lever open that 44% gap that’s a trough of City riches.
For many people that could be the difference between enjoying a secure and comfortable retirement versus living in fear of running out of money.
The reality of being on the wrong side of the passive vs active investment cost gap is even worse than illustrated though.
Your investing horizon could easily last over 60 years when your wealth-building phase is added to your retirement years.
That’s a long time for high fees to negatively compound against you.
The upshot is that active vs passive fund costs make a critical difference over a lifetime. Do not underestimate them.
Don’t fall for it
If you still find it hard to believe that a multi-trillion dollar industry can largely be based on smoke and mirrors then let’s get a final sense check from Warren Buffett:
The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.
Both large and small investors should stick with low-cost index funds.
Enough said.
Take it steady,
The Accumulator
P.S. Many other investing luminaries have spoken in favour of passive investing vs active investing. The Investor has put together a small selection.
There is also much more research available from the academic community that finds overwhelmingly in favour of passive investing.
An interesting starting point is the literature reviewed by the FCA. You can find a list of sources on page 104 and 115 of the FCA’sAsset Management Market Study – Interim Report.
