Caution to All Passive Index Investors – Beware the High Winds!

Hai guyz! What’s happening?

How was your weekend! Enjoy the winter chill much?

Yesterday was pretty insane, waking up at six in the morning so I could be chasing little kids around the park (I’m a soccer referee).

The wind chill and gusts felt like playing in a gale on the Arctic Tundra.

In fact, it was so bad at one stage that the pegs holding the goals down snapped off and the goals flipped over themselves (they were the fancy mobile goals).

Immediately after that, I made the decision to call the game off.

You should have heard the reactions from the parents when it happened.

“WTF TheFrugalSamurai, don’t be soft! The kids just want to play”. Well hello to you too sir.

“TheFrugalSamurai you fffffff – we could have just moved to another field”. I agree Ma’am, top of the morning to ya.

“We were happy to stand on the goals you dumb fffff”. Yes indubitably, there may be a higher chance of precipitation in the afternoon.

Ahhhh, such is the life of a referee eh – no matter what decision you make, you’ll always upset some people.

Sometimes though it’s not about making what is the popular choice.

It’s about making the right choice.

The popular decision was to go ahead, let the game go on, have the kids enjoy themselves and keep the parents satisfied.

But honestly, that would have been the wrong decision.

Because the risks would have far outweighed the rewards.

Letting the game go on blatantly ignores the events of the past (goals flipping over).

Moving to another field does not mitigate the risk of the event occurring (you can’t control wind direction).

Having parents stand on the goal posts only transfers risk (a parent falling over and injuring themselves, or worse the goals flipping over onto THEM).

All of these decisions would not have justified the risks involved.

Applying this to the investment world and the similarities are uncanny.

The popular choice is so often to chase the crowds and to be caught up in the herd mentality.

Think Cryptomania, Stockmarket Bubbles, Housing Crises – all created and marked up through herd investing and following the crowd.

It’s the most socially accepted and buying into these markets allows you to join in the conversation, to be and look “cool”, to feel included.

Yet, is it truly the right choice?

I say this because I’ve been more and more aware of the popularity of indexing when it comes to people who have been chasing FIRE and amongst Millenials in general.

Indexing or otherwise known as “passive” investing is whereby an individual captures the overall performance of a (major) investment index, e.g. S&P 500 and their investment return mirrors the ups and downs of that index.

The US S&P500 index (most commented on) is breaking record highs seemingly everyday. Other indexes have followed suit, which has continued to attract the attention and savings of increasing numbers of Millenials (read here and here).

The premise of doing so is that it is often argued that an investor will do better with the “passive” investment returns of an index compared with a more “active” approach (through direct shares, mutual funds, hedge funds etc.) given the higher fees, transaction brokerage and insecure performance in the long run.

Warren Buffet made a famous bet with hedge fund manager Ted Seides that the 10 year return of “the S&P 500 stock index would outperform hedge funds. He argued that, over time, active investment management by professionals would under-perform the returns of amateurs who were passively investing” (read article).

Fair enough.

Anything Warren Buffet touches, automatically is blessed with credibility by the Oracle of Omaha.

Hence why, “passive” investing in index funds is all the rage now.

But is it the right choice?

To determine this, you need to understand how the index fund itself is structured.

The funds themselves tend to be algo-based, which means that algorithms (computery science thingys) run and control the balancing of the fund to mirror the exact movements of the underlying index.

Now algorithms work well when the index is moving up – that is when demand exceeds supply and prices track upwards. More points up, more people want to invest, more the cycle continues.

But we saw in February of this year how dangerous and swift it can be when it turns the other way.

When the market is selling, the movements down tend to be harsher and steeper than the movements up – this is because the algorithms are falling over each other to get out, which causes more price pressure, which causes more algorithms to sell out.

I saw this first hand during the GFC with the waves of margin calls being implemented on unwilling investors (Margin Call is a movie starring Kevin Spacey, Demi Moore and that guy from the Mentalist, it’s also defined here).

It created a self-perpetuating cycle which meant more and more sell orders flooded through to exacerbate the downfall.

This is why there is no such thing as “passive” investing.

You can let the kids play (buy and hold) but that won’t help you when the gale storms blow through.

You can move to another field (re-balance and re-allocate your holdings) but that won’t provide you with any more cover.

You can allow some parents to stand over the goals and watch them (pay for professional advice) but no one can predict the elements (markets).

That is why whether you are a “passive” or “active” investor in any asset class, you need to watch your investments like a hawk, protect them and make a decision based on what you see fit.

Let the play continue if the conditions are good, but when the wind picks up and goalposts are being shifted, sometimes it makes sense to sit on the sidelines for a bit.

It might not be the most popular choice, but more often that not – it can be the right choice.

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P.S. Please don’t take this as personal advice and sell-out “because this amazingly awesome personal finance blogger told me so”, if you do – chances are this whole investing game isn’t one you should be playing in… do your own research and back your own decisions!