If you’ve ever done any home improvements, then you know how easily a small renovation project snowballs into a much larger one. Personally, I remember what started out as a simple exercise of stripping wallpaper morphed into removing dozens of bags of lath and plaster from our second floor! In the home renovation business, it’s called “scope creep”. Now, with more volatility in the markets, some investors are facing a similar dilemma.
With the advent of low-cost indices, the process of investing has been transformed. Growth in index investing has far outstripped traditional active management as investors have learned more about the high costs of most investment advice and have sought cheaper alternatives in response. This shift has been accelerated by the availability of robo-advisors, which offer automated, low-cost index investing.
With more investors following a passive investing approach, (their returns matching the market index minus fees), there’s the inevitable pull towards tinkering with the purely passive approach in an effort to boost returns. After all, no one likes to aim for “average”.
It’s easy to stick to our investing strategies when markets are moving up steadily and volatility is low. The hard part is sticking to our strategy when the stock market is oozing red or jumping around wildly. Watching global stock markets and our investments tumble has prompted some soul searching among passive investors. Some of us wonder: Should I take some kind of action? Are there bargains out there to be had?
Remember that, as soon as we try to predict the best time to invest more in stocks, look for an underperforming market, or pick an undervalued stock, we’ve now become active, not passive investors because we’re making a call on market or sector direction. Maybe we’ll be right or maybe we will be wrong. This could lead to outperforming the index—or underperforming it.
The main difference between active and passive investors is, active investors aim to beat the market index, whereas passive investors trust in the long-term success of the index. Index investing is successful for two key reasons: funds stay invested through highs and lows in the market, and winning stocks are automatically added to the index, while losing stocks are dropped. Tinkering with the passive approach negates these benefits, and most likely leaves investors worse off than if they were active investors, since they are creeping into a new investment process without a well-thought-out-plan. Active investing requires investors to make the right call twice: when to buy and again when to sell. That’s a lot of pressure.
With home renovations, the one advantage of scope creep is that, even though you’ll certainly be paying more for the extra work, you’re nearly certain to end up with a better result. That’s not necessarily the case for investors.