Everything is an Active Decision
Andrew Hill - Aug 06, 2021
Everything should be made as simple as possible, but no simpler
- Albert Einstein
There is a tendency for people to distill complex matters into simple terms. It may be because the simple answer is often the correct one, or because simplicity is akin to understandability. Dissecting the nuance of an issue requires a lot of energy.
How often have you heard someone say that a sitting President was responsible for strong economic growth or markets? While the President has an important role to play, the direction of a complex global economic machine cannot be completely driven by the actions of a single individual.
For decades, the debate between active vs passive investing has raged, often oversimplifying the complexity of the investment decision making process into binary terms.
But, the fact of the matter is that every investment decision we make is an active one. There is truly no such thing as completely passive investing.
Along each step of the investment planning process, we are faced with a multitude of options that cloud the landscape.
And if it wasn’t already challenging enough, we need to contend with our deeply held beliefs and biases that may guide us in a suboptimal direction.
Throughout the process, every investor must decide not only WHAT to invest their money in, but also HOW to execute on their investment decisions.
Each of these decisions has their own complexity and challenges
What we invest in is arguably the most influential investment decision we will make.
Simply put, asset allocation – how much we invest in stocks, fixed income, real estate, crytpos, commodities, etc – is likely to impact our total return more than any other choice we make.
In a truly passive world, we would have a static portfolio, representing some proportion of total global assets, that could meet our needs now and in the future. In the real world, our goals and circumstances change, as does the market environment.
On top of this, our investment decisions are too often influenced by our experiences and biases. Our relationship with money is impacted by where we live, what our priorities are, what kind of wealth we have, what kind of wealth we grew up with, what kind of wealth our parents have, how we built our wealth, etc.
As an example, in Canada, your relationship to real estate may differ significantly based on your age or year of purchase. If you lived through double digit mortgage rates in the 80s, or experienced unimpeded growth in the mid-2000s, or if you are trying to enter the market now, your faith in the asset class, your understanding of associated risks, and your comfortability in purchasing property will be vastly different.
Even the most seasoned financial professionals are beholden to the impact of their individual influences.
Famously, Former Federal Reserve Governor Henry Wallich holds the record for the most dissenting votes among members (26 dissenting, 24 of which were hawkish). Wallich was born in Germany during the 1920s. His intimate experience with hyperinflation created a natural predisposition to believe that loose monetary policy would lead to out of control prices. Yet, with the benefit of hindsight, many of his dissentions proved to be incorrect.
These lived experiences will continue to push us in various directions. But a truly unbiased decision is one that ignores your past and focuses only on what you are trying to accomplish moving forward.
Once you determine what you will invest in, you must decide how to invest.
At the heart of the active vs passive debate, active stock pickers believe that there is value to be had in selectively choosing undervalued companies while passive indexers believe that the market, in aggregate, does a better job in making this decision.
But this completely misses the nuance of implementation.
Let’s say, for example, you believe that being a passive indexer is the most appropriate way to gain exposure to the US markets. You still need to decide HOW to get that exposure. Is it through an S&P 500 ETF or one that tracks the Dow or the Nasdaq? If it’s the first option, do you use a market cap weighted version or an equal weight one? Or do you prefer to establish your own balance between large cap and small cap US Equities? And for small cap, do you use a Russell index or an S&P small cap index. Lastly, as a Canadian investor do you hedge your currency exposure?
It should be clear by now, even the simplest passive decisions include a variety of active choices; each of which will impact your long-term risk/reward profile.
So what should an investor do?
Have A Long Term Investment Plan
To make as much money as humanly possible is a great goal, but it is generally not an investment plan. It is the kind of strategy that allows you to be swayed by emotion (fear, as well as fear of missing out), and may prevent you from properly assessing your performance in an objective way.
Having a plan involves developing goals, a strategy to meet those goals, and developing a set of criteria and questions to assess what may impact those goals.
Some of the questions you should ask yourself include (but are not limited to):
Am I overconcentrated in an individual stock or asset class?
Can I reasonably estimate the expected return? Will that expected return meet my goals?
What kind of risk is involved with the investment? Is the risk simply volatility and extended downturns or permanent loss of capital?
Can I afford a permanent loss of capital?
Can I afford an extended downturn?
Am I buying the story or do I truly have a grasp of what can drive the price up and down?
What will happen to my financial and real asset portfolio if interest rates rise or fall?
How do the investments interact with each other in different types of economic and market scenarios?
At the end of the day if you don’t feel comfortable developing and executing a plan yourself, you aren’t interested, or you don’t have the time, then you should seek the help of a professional advisor.
Their job is to help you actively manage your financial life.