“Passive index investing”, a false dichotomy

How often have you heard a phrase about passive index investing like “investing in the SPY over the last 20 would have outperformed the vast majority of actively managed mutual funds”? I can imagine this does not come as a surprise to anybody who has been exposed to media in the past decade. However, as with anything, it’s important to delve deeper into the arguments of both sides to decide for yourself whether this is advice worth following for you.

First, let’s quickly evaluate the sources of said investing advice. Friends and family aside, this advice often hails from investing channels like CNBC, Bloomberg, etc while investment advisors at banks will quickly refute those claims by touting the many additional “benefits” you can get from investing with them, and emphasize risk mitigation strategies to justify the exorbitant MERs levied as taxes on your hard-earned life savings.

Incentives

Generally, the advice doled out happens to align with the incentives of said advice-giver. Directly attributable to malice or not, seldom does this advice align with our personal needs and best interests. It is to the bank’s benefit that you let them manage your portfolio and keep it there, so they can rake in commissions, MERs, have your money on their books for them to further invest and benefit without returning gains to you, etc.

It is to the benefit of hedge funds, robo-advisors, and other key players in the market to encourage you to take part in passive index investing for similar reasons and to propagate the idea that you are not experienced nor knowledgeable enough to take part in this glorious science of investing.

Being trained to deposit money and buy up passive indices paycheque by paycheque regardless of the price is how we are trained to be “the greater fool”. Does it really make sense that we spend some 20 odd years pursuing an education so that we may begin a career which we work for some 40~50 years only to hand it all to the market to decide our fate as some sort of great arbiter?

A more well informed approach

This generally leads most “enlightened investors” to pursue a lazy portfolio construction such as the popular Bogleheads Three-fund portfolio which is well studied and has brought many investors plenty of success with very minimal fees. And as a hands-off investor, I’d look no further. However, as with anything in life, there are nuances to everything, and if you’re someone like me who is irked by the thought of putting your life savings solely in the hands of fate, or worse yet, a glorified salesperson, what options are there for us?

Passive investing is a very quick and simple excuse to be irresponsibly responsible with your wealth. It’s a luxury that those more fortunate can afford, but to those of us starting from zero, it can be an incredibly crucial mistake that sets us back many years, or worse, prevents us from reaching our goals.

Simply being invested in the S&P 500 for the past 89 years would have put you in a 5%+ drawdown of about 43.6 of those 89 years. As often repeated to justify the “buy and hold” of passive index investing, if you grew weary or needed cash during any of those drawdowns, you’d underperform someone else simply buying and holding for those 89 years.

This, however, is a false dichotomy and incredibly harmful — misleading at best. The assumption is that we as “dumb money” are too stupid to educate ourselves a bit to better maneuver around some of these crushing blows.

The true cost of passive index investing

If you entered the market around Apr 1999, buying and holding S&P 500 would have taken you through 2 drawdowns of 50%+, once in the dot-com crash, and a faster, more traumatizing 2008 crash. The act of “averaging in” or “averaging down” across this period would smooth out these swings a bit, but for the most part, you’d be at a loss (and at best, breakeven) for a total of 14 years.

Think about 14 years of human life. How much goes on during this time? In the last 14 years, how many jobs did you change? How many friends did you gain and lose? How about a career change? Children? Did you endure the horrible loss of a loved one or a pet? While 14 years may have felt like a flash, it’s a considerably long time and a good chunk of the average human lifespan, 19.2% to be exact (using 72.9 years).

Is it reasonable to expect someone to be able to hold through these 50% drawdowns that feel like they’ll never recover while they go through all these life events and possibly need money for medical emergencies, weddings, a house, a car? I think not.

In hindsight, “holding through a 50% drawdown” is infinitely easier than it is in practice. Any person who has given a genuine try at investing will attest that in the moment, even a 30% drawdown can feel insurmountable and take a major toll on your confidence, perhaps even your job and loved ones.

Simply put, much like getting a degree and preparing for education, investing is a skill that can be learned and worked on, so long as we are willing. Given the effort most put just to start their careers, and the return most will reap from those same careers, learning to better invest and manage our hard-earned dollars accumulated throughout our careers is arguably more important and warrants more attention than simply buy and hold passive index investing.