The great active vs passive investing debate

This is a huge topic, potentially a bottomless pit. There are deep theoretical arguments one can wade through about the relative merits of each approach. Then there is the more practical approach of picking out examples, or reflecting on your own experience of trying to pick stocks or time the market. It’s hard to know where to begin, but let’s try to lay down some thoughts on this.

Efficient Market Hypothesis

Starting with the theory, most economic doctrine is underpinned by this EMH premise, which makes a lot of assumptions about rational behaviour, perfect information, etc. Basically everything is already in the price thanks to the efficient market. If you believe this, then it leads towards a passive index approach, because there is no value arbitrage to be monetised via active investing.

I don’t believe markets are efficient in this sense. You just have to look at the bubbles and crashes to see that the level of price variation goes far beyond the movement in fundamental asset value. Largely this is because of human behavioural aspects, e.g. fear and greed, which defy the assumption of rational behaviour. So then, does that make me an active investor ? Well not really nowadays, but I have certainly tried over the years. Basically I evolved to the view that it is possible, but not easy, to beat the market. A safer and more reliable approach is to simply accept market returns, focus on asset allocation and minimise costs whereever possible.

Follow the smart money

It’s funny to hear phrases like this. I thought all those $20 notes were the same, but apparently some are smarter than others. And then there’s the “dumb” money going into passive index funds. Diworsification, as some traders/investors/fund managers might mock. You hear comments like “why would you want to buy the index when it means you’re going to own BHP / WOW” (or in the past it would’ve been TLS, or whatever company/sector is out of vogue). I don’t really buy into these arguments. Call me cynical, but if someone really had an investing edge to sustainably beat the market, then they should be smart enough to use it to their own advantage and bet their own money (with leverage of course). I guess most of them must hope for healthy overall market performance in which case many investors will gloss over the issue of performance vs benchmark and fees.

There is one glaring case that deserves a special mention. This of course is Warren Buffett and Berkshire Hathaway. Surely this must be the poster child for active investment. But is he the exception rather than the rule? Statistically you would have to say so.

Stock picking and market timing is foolish

At the other end of the spectrum, you will hear index advocates pan active investing as foolish and pull out any number of statistics to support their view. You will read a lot of this especially if you hang around bogleheads, MMM, etc forums. While I have gravitated towards this end of the spectrum, I am certainly not in this camp either. As I said already, I believe it is certainly possible to beat the index, just not easy. However for those who have the interest, desire and mindset, I think it certainly is a valid approach to pick stocks and/or time the market. Some of the biggest investment opportunities I have seen in my lifetime have been during market crashes (2002/3 Iraq war, 2008 GFC). If you had the temperament and conviction to buy when everyone else was running for cover, then these opportunities (that will come up a handful of times in your life) are huge shortcuts to FF. Of course, the opposite is also true. If you don’t have the temperament and discipline, then you will end up buying the bubble and selling the crash, which is a great way to extend your working career. I will say it again, it’s not easy to beat the market. One might think bottoms and tops are easily spotted on a chart, after the fact. They are much harder to see at the right end side though. And further to this, even if you can pick the top/bottom, will you have the conviction to trade it.... Or will you lose your neutral, unemotional view and get caught up in the fear/greed like most others ? I’m convinced the mindset factors are critical to success. Unfortunately human beings seem to be hard wired to fail at speculative investing. As I read somewhere, you need to reverse your natural instincts. Learn to be fearful with your losing trades (cut loss) and greedy with your winners (let profits run). Most people are fearful with their winners (worry about giving up gains / being “wrong”, take profit early) and greedy/stubborn with their losers (hold on and hope, usually as losses get magnified).

So far I’ve been talking market timing but how about stock picking - can one even hope to compete with the army of market analysts out there ? At risk of sounding like a broken record, I think it will be tough. Even to find the time to read all the annual reports and company disclosures nowadays is a challenge. Also one of the key drivers is the quality of management. Is it possible to really judge this as an amateur investor who will never be granted a private audience with the CEO and management team of a listed company ? It really takes skill and effort to succeed here, but again, I’m sure it’s possible. Personally if I had to pick one or the other, I would choose market timing as a better chance of success, purely because of the market cycles of fear and greed that you can try and gauge (provided of course that you can remain adequately detached yourself!).

Willingness, capability and need to take risk

I think that’s a quote from the bogleheads, and something I’ve found quite instructive. For me, nowadays, there is not much need to take risk. Therefore I’ve kind of ended up ditching any thoughts of active investing. Even though I believe it’s possible and I have an interest in the area, why bother if there is 1) no need and 2) bearing in mind my view that it’s not easy to achieve a positive result. If I was starting out again, or still on the journey to FF (i.e. 1) does not apply and there is a need), I guess I would be tempted to give active investing a try. It is yet another “shortcut to riches” that I have written about before. But I hope ultimately I’d have the sense to follow my own advice and stick with the boglehead approach, which I have now broadly adopted (although not in a religious way). Nearly all of it resonates with me, especially the part about minimising costs (why pay for your fund manager’s Ferrari). I think investors are spoilt nowadays to have index ETF’s with such negligible fees. Really when you think about it, having the opportunity to invest in 100’s or 1000’s of companies with a relatively small amount of capital and paying <0.2% p.a. Most people would be best served to be thankful for such facilities. Just take this easy option and find a less costly hobby. Old habits die hard though, and on the market timing front, I haven’t entirely given up : I am holding a decent cash allocation and hoping I will have the courage to “fill my boots” should another serious market panic arise in the coming years. I do slightly regret missing the previous few opportunities I’ve had in my investing lifespan.

Active investing

I’ll just finish with a few thoughts on what it might take to succeed as an active investor. As already stated, I’m not an active investor myself so take it for what it’s worth...

Firstly, should you DIY or delegate to a fund manager ? I think it depends on your capability, interest and approach. In most cases, it will be better to use a fund manager. And if you DIY, you should mentally consider it as though you are employing yourself as a fund manager. Sounds a bit silly/contrived, but basically you need to have two hats, one as the investor and another as the fund manager who works for the investor. This fund manager should prepare an investment plan, quarterly reports to review results and actions taken. The investor could even pay the fund manager (a notional payment of course, it’s all your money afterall) a fee of say 1% of funds under management, and see if this fee is recovered or even outperformed. Basically the point is you have to treat it like a pro. If you are going to be an amateur / hobbyist, then either don’t do it (use an active fund manager or go back to indexing), or keep the percentage of assets low, e.g. 20% max, to minimise the risk to your hard earned stash.

Secondly, if you decide to use an active fund manager, the question will arise of how to pick one. As many researchers have shown, past performance is not a reliable indicator. So I wouldn’t just pick the fund with the best returns last year. Really you are betting on the fund manager’s skill and capability so it makes sense to get to know the fund manager. As a minimum, read their prospectus and market reports. Do they have an active website/blog which gives good insights into their investment approach. Do you understand what they are doing and their strategy to beat the average market return ? Are their fees reasonable ? These are the questions I’d be asking myself. If all else fails, there are some Listed Investment Co’s in Australia and a very notable one in the US that have a long track record of solid performance and reasonable fees. They might be a good starting point for your research!

Where did our wealth come from ? Part three

The aim of this third post is to draw deeper insights into how we achieved FIRE. So far we have established that the majority (approx two thirds) was derived from retained earnings, and one third from investment returns. This seems to tell you what we did but not really how we did it, i.e. what did we do differently than the average person/family to enable us to retire so much earlier. When I first conceived this post I intended to perform some kind of benchmarking analysis. For example, the average person earning X, spending Y, .... and compare this against our earning A, spending B, .... ; to try and build a bridge spanning the 27 year gap between our early retirement versus conventional (let’s say 65 years). Maybe I will still do this one day, but I can’t be bothered right now – sorry! Instead I am just going to try and list out the key things we did differently from most other people, and then try to judge which of these differences really made a difference. I hope this will be more useful and insightful than just stopping at the usual message: save more / spend less (although that actually is the crux of it!)

What did we do differently ?

Flying start (new car, no debt, no HECS)

Double Income No Kids until 30’s

Property Investment and accelerated loan repayment

Overseas “Expat” for 12 years

Carless decade

Frugal spending

High salary / career progression

Which differences really made a difference ?

To varying extents, all of the above strategies helped us reach FF in fast time. Some of them probably saved a year or two of work, others maybe cut a decade or even more. Some of them are also inter-related. Let’s go through them one by one...

·        Flying start (new car, no debt, no HECS) : This certainly was a boost, partly down to part-time work and saving while studying at Uni, and partly generous parents who wanted to pay off my Uni fees. I guess it’s not a silver bullet, but probably a year or two of head start versus the average person with a car loan / HECS debt.

·        Double Income No Kids until 30’s : I used to think this was a huge factor, but so far after 3 years of parenthood, I’m starting to wonder if the kid factor is not such a massive financial drain as what I had feared (perhaps its still too early to say). Also, I personally wouldn’t advocate making this life decision based on economics. For us, it took quite some years before we felt ready and excited to have kids, and there were periods when we questioned whether we would have them at all. The biological clock certainly played a role as a forcing mechanism and we are both extremely glad to have two wonderful children. Having said all of that, I think financially it is far more optimal to be DINKs and save/invest the surplus in your 20’s. I guesstimate this can be worth 5-10 years versus a couple who have kids in their early 20’s, and resultant impact on earnings (career break / slowdown) and expenses (childcare, kids costs, etc). Again, to reiterate I wouldn’t advocate deferring kids for financial reasons. If you know you want kids and are ready and eager to have them, then go ahead and do it !

·        Property Investment and accelerated loan repayment : I think the key factor is the last part. Our serial property investment was an effective forced saving mechanism. We didn’t overleverage. I feel our investment performance was neutral. We didn’t pick great properties but we didn’t pick lemons either. We had a good run overall with tenants over the years. It probably helped us get there a bit faster but I honestly don’t feel it made a huge difference versus if we had stuck it in index ETF’s and not used any leverage over all the years.

·        Overseas “Expat” for 12 years : The first seven of those years were on a traditional multinational company expatriate package, with lots of generous allowances and equalisations. This was a big income boost and enabled us to increase savings substantially. Not all expats capture the benefit, many spend or travel it away. In our case, I think we enjoyed ourselves but also tried to make the most of the financial opportunity. Aside from the salary aspects, there are factors like being a tax non resident of Australia. I think we didn’t capture this opportunity nearly as much as we might have in hindsight. In particular, with investment more in shares than property to capture greater benefit. As per the kids factor, I think key life decisions such as this, i.e. where do I choose to live, should be made holistically and not just based on economics. The opportunity to live abroad for us brought many positives to travel and experience different cultures, and the fact we could get ahead financially was the icing on the cake. I guess this helped us quite a bit, perhaps a 3 years short cut, off the top of my head.

·        Carless decade : We were lucky to live in big cities with excellent public transport systems (i.e. not places like Oz, US, where it’s hard to live without a car). Car’s are a financial drain and living without one for 10 years must’ve saved us a fair amount. Again it’s not a silver bullet, but would’ve contributed perhaps a year or two of avoided work.

Just a process check, adding up the above I get roughly 12 years worth of avoided work. We reached FF approx 27 years earlier than conventional retirement age, so that leaves another 15 years to account for. And that brings us to the two generic early retirement “must dos” – earn more / spend less.

·        Frugal spending : I’m unsure whether we are really frugal people, but let’s go with the description nonetheless. As I’ve mentioned, we have never been in the habit of budgeting or tracking expenses. But definitely I would consider myself tight with money and someone who likes to bargain hunt, I’m sure I inherited that from my folks. Some of this has inevitably rubbed off on Mrs FFA too after hanging around with me for so long! We are not materialistic people and spend little on clothes or brands. The purse strings have certainly loosened a lot over the years, and definitely we have accumulated our fair share of useless “stuff” and made some stupid impulse purchases just like nearly everyone else does. That was a bit of a ramble but to cut to the chase I would estimate from a NW accumulation perspective, these “frugal” tendencies carved at least some 2-5 years of work versus the average. But don’t forget a lower spending level has the double whammy effect of faster NW growth AND lower NW required for FF. The latter is a much more substantial effect in our case. Our typical annual spend of $30-40k (including two kids) is far below the numbers I see for “comfortable retirement” which are of the order of $55k (and that’s for a couple without kids). If one’s spending is 40% lower than the average, then one can also accumulate 40% less in retirement funds. That is a huge shortcut; decade(s).

·        High salary / career progression : Without going into details, my salary has been above average and career progression relatively good/fast. I had a good run for 18 years. Benchmarking against an average income, I expect this is a big factor driving our early FF. It’s also the reason we managed to achieve such a high savings rate of approx 80%, which was more about high earning than extreme saving. I guess this was worth at least 10 years, probably more.

Summary

This post identified seven things we did differently from the average person and attempted to guesstimate how many years each of these factors contributed towards earlier FF. In our case, a successful career, an extended period as DINKs, and frugal spending are the key factors. As I have stated in earlier posts, increased earning and reduced spending are both very important but if I had to pick one I would target sustainable spending reduction as the most critical driver of FF (due to the double whammy and controllability). I hope this gives you some insight and ideas on how to plan your own path to FF.