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I know what you’re thinking, punk. You’re thinking “did he fire six shots or only five?” Now to tell you the truth I forgot myself in all this excitement. But being this is a .44 Magnum, the most powerful handgun in the world and will blow you head clean off, you’ve gotta ask yourself a question: “Do I feel lucky?” Well, do ya, punk?

–Harry Callahan, The Motion Picture “Dirty Harry”

Active vs. Passive: The age-old debate that misses the real issues.

One of the most common and often heated arguments among investors is on the discussion of active versus passive investing.  The passive investors will argue that since most active managers do not consistently beat their benchmark, investors should simply buy an index fund and call it good.  

The passive crowd includes some heavyweight names like the late Bogle, Ellis, and Burton and fund families such as Vanguard and Dimensional Fund Advisors.

Passive indexers believe that the markets are efficient and that the goal of every investor should be to capture the market’s returns at the lowest possible costs. 

I will concede that (a) most managers do not consistently beat their benchmark and (b) markets are generally efficient. But does this mean I think investors should simply follow a simple, passive approach?  No. No! 1,000 times no!

I have long believed and discussed that the whole argument of passive versus active misses the point and is just noise compared to the bigger issues at hand.   Those issues are: (a) investors need to save more than they spend so as to be able to accumulate sufficient assets for the future; and (b) that investment, i.e. market returns, are random, and that the sequence or distribution of market returns is of absolute of critical importance to investment planning.

The key assumption being made by those who believe in passive investing is that the market returns will be adequate to fulfill the investor’s financial goals.  Maybe they will but maybe the won’t.

Unfortunately, such an approach leaves much to chance.  The future is, after all, unknown.

Several factors come into play when choosing a passive investing approach.  Timing is one. Institutions are less concerned about timing as they view their investment horizon as perpetual and ongoing. Additionally, institutions often benefit from a constant stream of new investment contributions.

Market valuation is another important factor — one that I will explore separately in a future post.   

The importance of timing.

For an individual, however, who must first save and then rely upon those savings to grow to meet their future financial goals, the importance of timing cannot be overstated enough.  

While the sequence of return risk can apply both in pre-retirement and post-retirement, it has the greatest impact on the latter as individuals are often selling assets to maintain their lifestyle.   

Here are a couple of examples of two individuals who retire with the same sum of money, each taking 4% of the portfolio value for living expenses.   

Market results with and without 4% annual withdrawal at year-end for period 1980-1992.

Market results with and without 4% annual withdrawal at year-end for period 2000-2012.

For the investor who retired in 1982, they experienced nearly two decades where the average return was near twice the market long-term average. This investor would have enjoyed the ability to receive a rising distribution from their portfolio and have more than what they started with nearly two decades later.

An investor who had the misfortune to retire in 2000 had a much different experience than an investor who was fortunate to retire in 1982, right on the cusp of one of the greatest bull markets ever.  

The second investor would have been in a battle for investment survival.  What the tech crash of 2001-02 didn’t decimate, the credit crisis and market declines of 2008-2008 probably did.  After a decade, the average return for our unlucky investor would have been 0% — and if this investor was having to sell assets along the way to supplement their lifestyle, their results were likely to be worse.  

Much worse.

These are two different experiences in which the only difference is where an investor is in the continuum of market returns.

Another excellent illustration of this comes from an article by Dr. Wade Pfau who has written some excellent papers in the area of retirement income planning.   Wade’s article, “You Can’t Control When You are Born…Revisiting Sequence of Returns Risks“, addresses my concerns square on.

In the example Mr. Pfau provides, he displays the following table showing investment results for 151 hypothetical different investors who save the exact same amount of money and experience the exact same average return.  The only thing different is when the investor begins and thus, what sequence of returns the investor experiences.  

Though they could expect wealth equal to 10x their salary, the outcomes ranged from a minimum of 2.98x to a maximum of 27.7x.  The difference in results is only explained by the order in which the returns occurred.

To quote Dr. Pfau: 

“This is sequence of returns risk! People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.”

This, readers, is why I am so adamant that a prudent investment policy must include active risk management, and why I build a risk management process into everything I do.  For an investor who experiences a significant portfolio loss late in their investment cycle, it is quite possible that the investor will never be able to fully recover and thus be able to experience the retirement lifestyle they had planned.  

Since none of us know what the future returns of the market are going to be, our only other choice is to make sure that we follow an approach that can reasonably protect our portfolio from large losses.

The active vs. passive argument focuses your attention on whether or not your returns are “as good as the benchmark” but it says nothing about whether or not the benchmark returns themselves will be adequate in magnitude or in a sequence that assures your investment goals are met.

Since investors don’t get to choose when they get to invest and retire as this is determined at birth, we prefer an active approach with the goal to minimize downside risks and maximize upside returns no matter when an investor is investing.

So the next time someone suggests to you that you should just go buy an index fund, ask yourself: 

“Do you feel lucky?  Well do ya…?”


Tim Fortier has been building quantitative models since the 1990s, and is well versed in tactical and factor-based approaches to portfolio management. He specializes in rules-based investment models with active risk-management.