The Truth About Passive Investing

Some say that there is no such thing as a pure passive investing, just fifty shades of active investing. Even indexing is considered a form of active investing, because of the frequency of rebalancing.

Others point out that passive investing has nothing to do with the frequency of transactions and everything to do with the ability to impact the direction of a company you are investing in. The latter definition makes every form of public investing passive (with the exception of activist investing).

No matter the definition of passive investing you believe in, we can probably all agree that indexing has provided a cost-efficient way to invest in the growth of the world economy.

S&P 500 annual return (ex. dividends)

There’s nothing wrong in indexing (buying the S&P 500 for example), but you need to understand what exactly are you buying and decide for yourself if you can do better.

The S&P 500 goes through frequent rebalancing. It replaced ten stocks in the first three months of 2017. Some of the changes are due to acquisitions; others are due to poor stock performance. First Solar is one of the stocks that was recently replaced.

The S&P 500 is essentially a slow trend-following program run by a committee of people. The rebalancing is not based on strict technical rules. A group of people sits and decides which stocks to add and drop based on market capitalization, liquidity, domicile, float, sector classification, financial viability, length of time spent as a public company and the stock exchange it has been listed on.

The selection criteria have produced some odd timing. For example, AMD was recently added to the index, after a 500% move in the past year and a half. Do you think you can find a better entry spot?

While its timing has been often poor, over time the S&P 500 has managed to capture most long-term winners. It has kept the long-term winners and dropped the losers, many of which eventually went out of business.

About That Jesse Livermore Quote

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”

The above-mentioned quote is probably one of the more frequently cited in trading and investing circles. Many forget that there is an important nuance to that quote. It is the holding of great stocks in a bull market that will make you money. Try staying with a great stock through the turbulence of a bear market and then tell me how your holding is making you a ton of money. There are several things to consider:

1. You will experience several bear markets in a 40-year investment career and much more >15% declines in the stock market. You need to have a plan how to deal with them. A bear market can lead to a 50% or even 90% drawdown in any stock regardless of how great its fundamentals and its growth prospects are.
2. Not all stocks will recover after a deep market decline or it might take many years until they do. This is what market history has shown us over and over again. While well-diversified indexes tend to come back, individual stocks have had very different stories.
3. Very few can stomach a 50% or 80% drawdown in a stock. Most get scared and sell near the bottom. You think you are different and you will act cool, but you never know if you haven’t experienced it. Besides, you also need to consider the emotional toll and the opportunity cost of capital.
There is no difference between owning a stock that goes up 1000% in 10 years and owning a different stock every year that goes up 39% that year. In ten years, you will get the same return, assuming a 20% long-term capital gain in the first case and a 39.6% short-term capital gain in the second case. There’s no difference in the end result, but there is a huge difference in the experience. The first requires going through deep drawdowns which few people can stomach. The second comes with a lot smaller drawdowns and it is easier to implement.
Only 28 stocks went up more than 1000% for the past decade. This number would be a lot larger if the starting point is the bear market bottom in March 2009. This is why market timing matters.
There are more than a thousand stocks that went up more than 39% in the past year.
The odds of catching a few stocks that gain more than 39% in a year are a lot better than the odds of capturing a 1000% gainer in a decade.
Apparently, you can’t trade frequently if you manage over a billion dollars due to the sheer size of the capital. Trading often is also not an option if you don’t have the required time or the skills to do it.
The above-mentioned challenges are not new. They have been with us for decades and the financial community has found different ways to deal with them:
1. Some have decided to stick with well-diversified stock indexes and to add hedges. The result is smaller returns and smaller drawdowns. There is nothing wrong with this approach if its returns will be enough to achieve your goals. Some people have an unrefutable proof of years of poor returns that they cannot beat a plain vanilla 60/40 portfolio. Not everyone can be good at everything. It is ok to admit it. There is no shame in it. Once you do, you can dedicate your time and efforts to building other businesses and a career.
2. Indexing is not the only way to approach the challenge of inconsistent returns and market volatility. Market timing, stock picking and constantly adapting to changing market conditions can do that for you as well and deliver you a lot higher returns. No one says that is easy. It is not supposed to be easy. Otherwise, everyone would be able to do it and therefore the returns will be a lot lower. No business is easy. Each requires constant innovation and hustle.

Earnings Surprise + High Short Interest = Big Profits

Financial markets tend to underreact to genuine surprises and overreact to know threats. When a company reports better than expected earnings and sales number, it receives a positive reaction to their numbers and it has a high short interest, it can deliver hefty returns in a short period of time. CONN and RH are two recent examples. The new earnings season has just begun. It will likely provide several similar opportunities.