If you are trying to maintain your wealth there is nothing worse than being pickpocketed. For many years, financial services was just that, in between expensive products and commission led product salesmen, but as industries become more sophisticated, so too, does the ability to pickpocket you.
One of the easiest methods is to create simple misleading binary arguments that have no place in common sense or intelligent decision-making.
Thankfully, after thirty years analysing money, it’s easy to know which links to read, which newspapers to hoard and those to light the fire with.
The daily binary argument of passive investment versus active investment, is another pickpocket moment.
Passive investing is simply putting your money into a cheaply run product that just tracks a stock market index for example. It’s cheap and it’s great when the market is rising, as it doesn’t have the downside of expensive charges.
Active management looks for value in the stock market and is more expensive given the research required. It will typically outperform when there is no rising market and value has to be achieved by looking into detailed information on companies to buy, and which regions to invest into.
As with many ‘manias’, how many investors owned the mania for the first time, the month before it went pop. That’s how manias pop. And so investors are herded into the passive queue, then into the active queue, all at the wrong time.
There are times when either passive or active investment is appropriate, but today we might consider the risks that passive investment has introduced after the recent queue jump where over half a trillion dollars has moved into such products.
Investors are automatically invested into stocks via passive investing, irrespective of whether or not that stock is fair value. As the money comes in, you are automatically invested into that stock irrespective of its chance of rising.
In the past, a stock rose based on popularity. That popularity was created by researchers with intellect who knew enough about the stock to want to buy it.
Therefore, in a market downturn, good stock pickers know which stocks to buy and sell based upon real value. Given current stock market overvaluations, those days appear to have gone, and so investors are railroaded into stocks their active manager wouldn’t place them in, as there would be no upside evident in the stock. Just because the pedestrian crossing beeps it doesn’t mean you should cross the road or do so without looking each way.
Think about it another way: If there was no such thing as active investment, who would know, or care, what to pay for a stock as it would all be automated with no sell point or buy point?
And so, passive investors may well be overexposed to those vultures that will sell short (basically bet on stocks falling and make lots of money) on those stocks that have been overinflated by the blind purchasing by passive investment funds.
The bigger the bubble, the greater the potential for circling vultures.
Right now, it’s hard to see where the value is in the upside of markets and stocks and until that sentiment catches up with the economy (if it does) why buy any more stocks?
Furthermore, certain sectors do well in certain financial cycles. Because a stock market index, (and in turn a passive investor) automatically ‘holds’ the biggest stocks in the index, this fuels that cyclical bubble further.
We therefore become exposed to stocks as opposed to the most deserving stocks.
Consider also what happens to a stock that is no longer eligible to be included in an index. As it exits the index, it loses the investment into it, probably at the same time the bets (those who are shorting it) are laid on, therefore driving its price south.
Most of this would be reflected in the price before it fully exits the passive investor’s portfolio and so the passive investor is hit with an arbitrary brutal slap in the wallet, whereas an active investor would have exited it a long time before knowing it didn’t represent value for money.
What happens to these bubbles when Trump hits another inappropriate tweet and rattles markets?
Have a question on investments or pensions, please call Worldwide Financial Planning on 0800 011 2825, email info@wwfp.net or visit us on www.wwfp.net.
Peter McGahan is the owner of Independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority.
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