11 Mar 2016 Persistence and Politics
Persistence is defined as “continuing without change in function or structure.” Webster’s second definition of politics is “a person’s opinions about the management of government.” Persistence describes a purposeful struggle against shifting winds to hold a course, while politics and politicians seem more and more purposeful in going with the shifts.
A similar relationship exists between the strategy of passive, or index investing, and that of active investing. The first continues without change in function or structure while the latter is directed by a person’s opinions about the management of companies, industries, and economies. The first seems dull or ‘establishment’ while the latter is exciting, even exhilarating. But should exhilaration really be an important component of our life-long financial investing? Just as in politics, we are drawn to the the inspirational story and suspend our more rational objections. The next best thing in technology sounds infinitely more appealing than a technology index, just like a free four-year ride at a major university sounds compared to $100,000 in college loans.
Problem is, undisciplined shifting to follow the latest inspiration is expensive. Rick Ferri and Alex Benke demonstrated in the Journal of Indexes in January 2014 that index investing outperformed active (stock-picking) investing 83% of the time, over a 15-year period. The extra 17% is not much different than random noise or pure chance. How expensive is being wrong 83% of the time? The study found that the median annual shortfall of losing active portfolios was -1.25%.
A 1.25% reduction in the investment returns of a 40 year-old couple who invests $90,000 annually for the next 15 years in an 80% stock portfolio has the impact of reducing their retirement spending from $100,000 to $60,000 for the rest of their lives, if confidence in meeting all other goals is held constant. In retirement, needs remain persistent while inflation relentlessly erodes the ability to fund them.
The persistent erosion of inflation on your lifestyle spending is largely unavoidable, but you do indeed have control over the erosion you allow in your investment portfolio. Active portfolio management exposes you to costs in at least three major areas that are avoidable with a passive or index strategy. They are:
- excessive taxes caused by unnecessary churning of your portfolio (plenty of political analogies here)
- high fees for management that does not add value or wealth
- under-performance relative to the index caused by the managers’ or the investors’ miss-guesses.
A better way to invest for your future goals is the dull yet persistent method of efficiently harnessing the wealth generation of the capital markets while eliminating as many of the drags as possible. Every 1.25% you don’t lose to under-performance or 1.25% you don’t lose to taxes or 1.25% you don’t lose to expenses increases your confidence of meeting or exceeding every important goal you value.
In an era where control seems to be slipping through our fingers, this is one choice, one vote that is a winner.