Thursday, May 19, 2016

A fight against passive investing to protect principal

It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.  - Charles Darwin 

The strongest current meme in asset management is passivity. It is baked into the index business. It is manifested in the ETF growth. Index growth is based on the passive buying of a basket of assets. The ETF growth is an extension of the index business that delivers asset baskets instead of skill-based fund management. This meme may be changing with smart beta, but there is still is an air passiveness based on the idea that there should be strict rules and structure not a dynamic response to events.

The decision to just hold a diversified portfolio across different asset classes is the strategic choice of many investors. This is the also the foundation of the robo-advisor investment revolution that finds stable diversified portfolios after a review from a set of risk tolerance questions. Investors do not have to make decisions but rather just hold and wait. This passiveness has served many well in the post-crisis period when stocks have moved up in a long-term bull market, but it is unclear what will happen if there is a market downturn.   

A world of passive decision-making is rational when the quality of decision-making is poor. Investors should not take action if the potential action is likely to be wrong.Yet, in a complex unconventional world, being passive may lay the foundation for disaster. 

The factor-based revolution gives investors a better chance to adapt to change. By following trends in factors, there is the opportunity to avoid a major market drawdown. Adaptability to avoid principal loss may be the only choice that investor needs to make and that decision requires vigilance and action. 

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.  -John Maynard Keynes

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