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Debating passive vs active investing: Episode I – The Lure of the Dark Side

Over the next few posts we’re going to try something a little bit different on Monevator.

We’re going to confront the tension that sits at the heart of this website. The fact that – despite commanding a bastion of passive investing [1]Monevator’s own head honcho, The Investor, has a foot, arm, leg, indeed his very heart and soul in the active camp [2].

Not to mention a large chunk of his portfolio.

What’s more, many of Monevator’s readers are similarly permissive when it comes to their investing philosophy.

So let’s have it out. Let’s cross wits and cerebellums. On the one side sits I, The Accumulator, High Priest of the Purely Passive. On the other sits The Investor, a Promiscuous Pursuer of Profit. Let’s talk about our competing philosophies, the risks we face, the opportunities at stake, and the rationale for our choices.

And after three such head-to-head posts from us, let’s open it up to you lot for a – sporting and well-mannered – end-of-year ding dong.

Hopefully we can still all be friends [3] at the end of it. Although I’ll warn you – discussions between The Investor and I can go one of two ways. We’ll either have a cosy fireside chat or a knife fight in a telephone box.

Let’s see what happens next.

Have at thee!

The Accumulator: So you started out investing in index trackers [4] but, like Anakin Skywalker before you, you couldn’t resist the lure of the Dark Side. What happened to turn you into an active investor?

The Investor: Hmm, my failure in the cave? No, I don’t think there was any one event or moment of insight – probably like Anakin I always had the Dark Side within me. I did run a high yield portfolio [5] of shares alongside my early trackers, and I did find them far more fascinating.

I then started investing in small cap value [6] shares of the sort that did well around 2000 to 2003. On the whole mine didn’t do that well – I lost the lot on one! So I wasn’t won over by some magical profitable trade, that’s for sure, although no doubt the thrill of seeing others go up did spark something.

Probably it’s a combination of my innate, sometimes annoying personal traits, together with the fact that the devil has the best tunes.

On the former, you observed once that some people just aren’t cut out to be passive investors, even if they see the logical case, and I’m probably one of them. I’d note to readers: This does not imply doing better! It’s about not being cut out for the process, not the results. Most active investors do worse – whatever delusions they harbour.

On the latter, those tunes, I like reading Buffett [7], Slater [8], Greenblatt [9], Graham [10], histories of hedge funds [11], and reports from the Great Crash [12]. In contrast, as you know I failed to finish Hale [13]. If only I’d made it to those last few pages, eh?

The Accumulator: Interesting. So you were drawn into the part of the forest that excited you? And if we flicked through our big book of behavioural finance we’d no doubt find the cognitive bias that confirms that people like to invest in securities that are more familiar to them or that give them more pleasure.

In the first instance, there is a comfort to be found in the idea that you know a firm inside out – you can create a more credible rationale for its future performance.

In the second instance, we know that people love the lottery. There’s catnip in the notion that you might hit the jackpot.

The thing is, isn’t investing a cold, hard calculation? We invest now to secure a stream of income [14] in the future. We want that income to be as high as possible, and anything that undermines that (like a bad bet) should be avoided like a Jawa with syphilis.

In other words, you should get your thrills from the dog track and your intellectual stimulation from the Ancient Greeks, but not the stock market?

You are using Bonetti’s defence against me, uh?

The Investor: I suppose there’s several answers to that – but first let’s just put in a standing statement that I agree with everything you say! That’s why Monevator touts passive investing, not active, as an investor’s core strategy.

I am not going to try to ‘turn’ you, or anyone else, here. This is just how I developed, not a recommended course of action.

The big thing is I find it trivially easy to save [15], so I’m not gambling my retirement if I do a little worse than the market for the price of entry into the stock market casino. So I don’t see a lot of downside, given how enthralling I find my intellectual poison of choice.

One thing that does frustrate me about passive investing writing, is a writer will say something like “Why gamble your retirement on active funds that could leave you eating beans in your old age,” whereas in reality, you’re still likely to be able to retire following an active path, especially now trail commission [16] to advisers has been abolished.

Of course you will probably do worse – compounded to say 20% worse – than if you’d been passive, or maybe at some point you’d realise that shortfall was coming and decide to save more money to avert it. But anyway it’s not passive or penury.

I think a lot of nasty things were in the same pot when I started investing – financial advisers [17]taking a big cut, opaque management fees, and little choice for pension funds and the like. It all reduced investor returns but the active part was only one portion of the comprehensively terrible picture.

In reality many people have done perfectly well as far as they’re concerned from a portfolio of large well-known active funds, or perhaps investment trusts [18]. We know they almost certainly would have done better with passive equivalents, but they may not and they probably don’t care.

Having said that, I invest most of my money in shares, not funds. I think if you have a fairly good grasp of what you’re doing, it’s arguably not too hard to do at least as well as active funds, after costs, due to their various limitations [19] – and I know that contradicts the standard “they have all the brains and better information” message.

The thing is, I think professional active managers are plenty hamstrung, too. No, it’s not an equal fight – we’re using different weapons – but it’s perhaps more of a fair one than some think.

I stress again that you do need a good grasp of what you’re doing. Crucially – and it’s probably going to sound arrogant to say so – I don’t think many people have that, even if they’ve been investing for years [20]. Picking shares is easy to do, but hard to do well. So again most will be better off passive.

I have the feeling I didn’t answer your question.

To further avoid doing so, perhaps I could turn it around and ask why you didn’t have a crack at active investing yourself?

I know you were bewildered like most of us when you first surveyed the investing landscape, but it’s clearly not beyond you. And you have many of the same personality traits that I do, albeit in a more rounded and socially-acceptable form. And you’ve got the competitive spirit, and have wanted to win – and have won – in other fields in the past.

Were you not – are you not – even a tiny bit tempted? Why did you assume you’d lose without trying?

Now read Episode II [21] of this titanic struggle to see the couch potato investors strike back! Remember, comments are turned off until the third and final post.