The three elements of money mastery

[Roman Empire]

I’m just going to throw this out to start a discussion about the negative and positive aspects of passive investing. RetireJapan writes in his latest blog post that the safe and steady approach of low cost, diversified and passive investing works best with larger amounts of money.

But passive investing is also a conscious choice to underperform compared to the market benchmark after taking out fees. Isn’t it the same as taking on unnecessary risk in a record-high market environment, like we have currently in many major markets around the world?

[N00bster]

But passive investing is also a conscious choice to underperform compared to the market benchmark after taking out fees. Isn’t it the same as taking on unnecessary risk in a record-high market environment, like we have currently in many major markets around the world?

"Beating the market" seems to be a promise that all actively-managed funds fail to fulfill anyway. Is there anything that makes you think than an active strategy is better when the market seems to be reaching a top?

[sutebayashi]

I think passive investing in broad indexes is good if you are in for the long term and plan to make consistent contributions.
As a result you aren’t putting all your money into the market at a single time, but dividing it up into hundreds of small investments distributed over many years.
This way you end up buying lots when they are cheap and less when they are high.

I avoid Japanese stocks myself, but I suspect the strategy would likely have done ok even if applied to the Nikkei225 over the last 30 years including asset bubble pop.
Not as good as for foreign markets though, excluding basket cases like Zimbabwe.

[RetireJapan]

Some thoughts (not particularly organized or backed up):

Passive investing (as mentioned in the blog post) is long-term investing in low-cost index funds: you should get the market return minus fees. Fees are extremely low (0.2% or so).

I guess the alternatives are day trading, buying individual stocks, or buying active funds.

Day trading incurs trading costs and taxes and takes a lot of time. Chances of success seem low for the amateur starting out.

Buying individual stocks seems risky: most of the index gains are from a handful of stocks, if you happen to choose the ones that don't do well you will underperform the index. In extreme cases your stocks can go to zero. If you diversify enough to avoid this risk you may as well just buy the index.

Buying active funds seems like a crap-shoot: it's impossible to predict performance in advance and fees are high.

At the end of the day active investors in aggregate get the market return minus costs, but their costs are higher. They are also competing with the professionals, who have more training, resources, access to information, etc. Why would an amateur believe they had an edge here?

[Roman Empire]

A book I own describes diversification as spreading risks across many securities whose individual risks are unrelated to each other. It says that a risk-averse individual can build a low-risk portfolio from a collection of risky assets if the risky assets are appropriately selected. The writer says that risk is a characteristic of a portfolio, rather than of an individual security.

Buying only passive index funds seems risky. It is not a safe approach to investing. Index trackers are not diversified in terms of risk if the underlying investments are all the securities listed on a broad index.

There are active stock funds run by various Japanese companies that have consistently been outperforming the TOPIX Index.

ETFs are indispensable for building a strong portfolio, and I love using them. But that should not be a reason to write off investing in active funds and individual stocks completely.

What do you think?

[Jamo]

I'm starting to feel like we're being trolled.

A book I own describes diversification as spreading risks across many securities whose individual risks are unrelated to each other.

So in other words, an index fund?

Buying only passive index funds seems risky. It is not a safe approach to investing. Index trackers are not diversified in terms of risk if the underlying investments are all the securities listed on a broad index.

You appear to be defining risk as the risk of not outperforming the market. If that's the case, your idea of risk is skewed. Risk means the risk of losing your money. As stated above the probability of outperforming the market through individual stock selection is minimal, and hence riskier. Buying only passive index funds is pretty much the least risky form of stock market investment.

There are active stock funds run by various Japanese companies that have consistently been outperforming the TOPIX Index.

And there are many more that haven't. How are you going to choose which ones to buy? And what is "consistent"...? 5, 10, 20 years? Try comparing them with an index fund over a 20 year period, after fees.

ETFs are indispensable for building a strong portfolio, and I love using them. But that should not be a reason to write off investing in active funds and individual stocks completely.

It's not. Most people on this forum probably invest in active funds and individual stocks in addition to passive funds. But the latter would usually make up the majority of their portfolio.

[RetireJapan]

Most people on this forum probably invest in active funds and individual stocks in addition to passive funds. But the latter would usually make up the majority of their portfolio.

In our portfolio, more than 90% is broad indexes. The other 10% probably should be too, but I can't help myself trying to be clever

[Roman Empire]

RetireJapan and Jamo -- you are intelligent enough to have a constructive dialogue about how to build and optimise an investment portfolio. Japanese investors make rational investment decisions. If you go to the homepage of Rakuten Securities or any of the other online brokerages you can find out what funds are popular among them. If the concern with active funds -- including those that have outperformed their benchmark continuously since inception -- is fees, it does not seem logical to invest into a robo advisor that charges more than one per cent. The way to choose which active funds to buy is by doing due diligence on the companies and portfolio manager or managers.

[RetireJapan]

Japanese investors make rational investment decisions.

This doesn't match my experience talking to people in Japan, although I don't think that is exclusively a Japanese thing.

If the concern with active funds -- including those that have outperformed their benchmark continuously since inception -- is fees, it does not seem logical to invest into a robo advisor that charges more than one per cent.

I think you are right about this, and have changed my thinking on THEO. I'll be writing about that in my December update. お楽しみ！:)

The way to choose which active funds to buy is by doing due diligence on the companies and portfolio manager or managers.

The problem with this is that we cannot predict the future. To a certain extent, active fund performance is random, and survivorship bias makes it difficult to evaluate them (put simply, firms will start ten funds, and then close the seven that underperform and keep the ones that do well). Repeat every year, and it's the same as if you took 100 people flipping coins. After ten flips, you might have a couple who got heads every time, but that is no guarantee that they will continue getting heads in the future.

Additionally complicating things, successful active funds suffer from their own success: it's much harder to deploy large amounts of money as effectively as small amounts, so the more successful a fund is, the more money comes in as investors want to invest in it, and the less likely the fund will be able to be as effective in the future.

For normal people, passive investing is much safer, much simpler, and has a greater chance of success.

For unusual people who want to spend a lot of time researching and managing their investments it may be interesting to pick stocks or try to find effective active funds.

However, almost everyone who doesn't have a conflict of interest, from Warren Buffett to Andrew Hallam to Burton Malkiel, says the same thing: most people should worry about their portfolio allocation and the fees they pay, and invest in index funds.

[N00bster]

If the concern with active funds -- including those that have outperformed their benchmark continuously since inception -- is fees, it does not seem logical to invest into a robo advisor that charges more than one per cent.

I think you are right about this, and have changed my thinking on THEO. I'll be writing about that in my December update. お楽しみ！:)

I am very surprised to read that. Would you mind to elaborate a bit on how your thinking about Theo has evolved? My understanding was that it was one of your strong recommendations.