The following is an extract from Morningstar's Mark LaMonica and Shani Jayamanne's new book, Invest Your Way.
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Just 30 kilometres outside of Philadelphia, Pennsylvania, sits the sleepy town of Malvern. Population: 3419. The town was best known as the site of the obscure battle of Paoli in the Revolutionary War, when British regulars surprised American militia in a night attack. The town is now known for something else: it is the headquarters of Vanguard, which manages just under A$14.8 trillion in assets. That’s a hard number to wrap your head around. It’s more than five times Australia’s GDP. Vanguard could buy every publicly traded company in Australia — 8.75 times over. Vanguard is the champion of passive investing and has become synonymous with the investing style. As passive investing has gained in popularity Vanguard has become a juggernaut in the investing world.
For years there has been a debate between advocates for active and passive management. It may be too early for either side to declare victory, but the momentum is certainly with passive. Investors will argue passionately about active vs passive. Within active management there will be advocates for certain strategies or approaches.
You won’t get that from us. We don’t think there is only one investment strategy. One of the tenets of this book is that there are multiple ways you can invest to accomplish your goals. We want you to find a strategy that you are comfortable with and believe in, that is right for your goals and your circumstances. That’s why we think these debates about the ‘right’ strategy are of little value.
However, the debate on actively managed versus passively managed investments does illustrate where so many investors go wrong. In this chapter we dig into the debate a bit further to show that it isn’t what you invest in that matters, it’s how you invest and how you frame success.
Passive describes behaviour and not investments
Vanguard founder John Bogle described passive investing in a straightforward way. Pick your asset allocation. Gain exposure to each asset class using a broad-based index and then do nothing. The passive part about following Bogle’s investment approach is not the investments in your portfolio — it’s you.
You do nothing and trust that over the long term low fees and better tax outcomes will make a difference. Trust that all this activity that investors go through making decisions on what to buy and sell and when to buy and sell only detracts from returns. Passive investing is based on the notion that investors can’t make good decisions consistently and end up owning the wrong things at the wrong times. Bogle famously summed up passive investing like this: ‘Don’t look for the needle in the haystack. Just buy the haystack.’
This is a passive strategy. No-one is picking individual investments that go into a fund or ETF, and the end investor is not picking what to buy and sell or when to buy and sell those products.
This compelling investment approach has attracted legions of investors to the passive camp. The problem is that somewhere along the way people lost sight of why passive investing works. There’s a difference between passive investing and using passive investment products to actively invest.
Buying and selling different passive investments is not passive investing. Stretching the boundaries of what is considered passive to narrower and narrower indexes that promise exposure to a compelling theme is not passive investing. Investing in products that follow an index with high turnover through constant rebalancing is not passive investing. Remember that the passive part of passive investing is not the products you buy. You are passive.
It isn’t what you invest in but how you invest that matters
John Bogle was a big critic of ETFs when they came out. To Bogle an ETF didn’t make any sense. If you are investing passively, why do you need an investment that you could easily trade. Bogle understood the downside of poor investor behaviour and was worried that the biggest selling point for an ETF — the fact that they are easy to trade — would lead to more trading. He was right. A study conducted by UTS in 2008 explored whether individual investors benefit from the use of ETFs. The study found that portfolio performance when investors used ETFs was lower than when they didn’t.
It wasn’t a small loss. The study found that ETF portfolios underperformed non-ETF portfolios by 2.3 per cent a year. In theory this makes no sense. The difference in returns is the result of buying and selling ETFs at the wrong time rather than choosing the wrong ETFs. A critical finding in the study was that ETF portfolios did outperform if the investor bought the investment and held it for the long term. Is there an inherent problem with ETFs? Of course not. The problem is us.
There is a difference between investments and investing. An investment is something you buy and sell, like an ETF or a share. Investing is a process. This book is about the process of investing. Most books about investing are about how to find the right investment to buy. We think the process is far more important. The success of any process comes down to a few common traits: patience, resilience and consistency lead the list. Investing is no different.
The inconvenient truth about investing is that our own behaviour is having a negative impact on our results. The good thing is that your behaviour is completely in your control. If you avoid mistakes, you will get better results than everyone else. Stop following the approach taken by many professional investors who frequently trade. They do that because if they have short-term underperformance investors will pull money out, which will hurt their livelihood. You have none of those pressures. The only thing trading too much is doing for you is hurting your returns.
Trading too much isn’t just an issue with investors who pick passive investments. Active fund and ETF investors tell themselves that they are letting professionals manage their money because they think it’s too hard to pick individual shares. Yet they constantly switch which professionals get to manage their money based on short-term performance.
Passive fund and ETF investors can be holier than thou. They quote John Bogle constantly, yet they don’t follow his advice. They switch passive investments frequently based on their perception of what will do well based on short-term market conditions. They buy high and sell low. They decide anything tracking an index is passive, even if that index has 10 shares that are selected fortnightly using a Ouija board.
Both active and passive investing can work, but we don’t think active investment works in the way it is practised by many fund managers. We also don’t think passive investing works in the way most end investors practise it.
Our point is simple and is repeated ad nauseam throughout the book. In investing we have met the enemy . . . and it is us. Changing your behaviour is hard. It means ignoring articulate people making compelling cases for and against investments. It requires immunity to highly paid and skilled marketers. It means dulling your emotions as your portfolio climbs and falls.
One of our favourite things about investing is that it is all about us. It’s us against the world. Maybe the playing field isn’t level and professionals have more time and resources than we do. Maybe they know more than we do. They may be far smarter than we are. Yet we retain control over our outcomes. It comes down to the basics: having a goal and a long-term strategy. Most of all, it means resisting the temptation to constantly chase returns.
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This is an extract from Invest Your Way, a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
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Mark Lamonica, CFA, is Director of Personal Finance at Morningstar Australia.
Shani Jayamanne is Director, Investment Specialist, at Morningstar Australia.