Passive Approach – Going with the market

Full disclosure right from the off. I take a passive approach to investing and go with the market.

Why? Because research shows emphatically that the majority of investors will earn a return equal to the market minus their fees.

As a result, the lower the fees the higher the returns. Throughout history, the market has always been generous to investors who are in it for the long term. Any other approach means going against the market, and that’s a big call.

Who is the market anyway?

The market is everybody out there doing trades, but when you look more closely at who is doing these trades it becomes a little scary. 95% of trades are carried out by institutions.

Just think about the resources all these pension funds, investment banks and hedge funds have at their disposal. I have to ask myself do all these day-traders short-selling different currency pairs really know who they are up against?

Who are we up against?

These institutions have piles of information that average investors and traders simply don’t have access to.

Whether that be through attending boardroom meetings with the companies they are investing in, or statistical data that they have paid for, it gives them an unassailable advantage.

We haven’t even mentioned all those armies of economics PHDs sifting through business reports.

To be honest though, I’m not half as concerned about any of that as I am about all those computer geeks working for them.

Picture the rooms packed full of the brightest tech and maths brains coming up with all kinds of advanced crazy algorithms to stick into their state of the art AI machines.

These machines have the power to predict how the average investor is going to react to things that haven’t even happened yet. In the time it takes for a human to count to one, these machines are making thousands of trades.

It is no wonder a passive approach to investing is becoming more popular by the minute. Through taking a passive approach, these investors have decided it might not be in their best interests to start trading individual stocks.

As sensible as investors using a passive approach are, many still aren’t prepared to simply go with the market. Even though the market has always been generous, they still want to do something to stack the odds in their favour.

A passive approach with a twist!

Many people who agree that we shouldn’t be trading against the institutions don’t bat an eyelid about investing in factor based funds, sometimes called smart data funds. There are many factors, but perhaps the most famous is ‘value.’

Value is a pretty simple concept. You buy cheap stocks and avoid expensive ones. On the face of it, value investing is a great thing to do. You are simply selling what is expensive and buying what is cheap.

The thing is, I can’t really see the difference between choosing value and picking individual stocks. The minute you chose an individual stock or invest in some kind of factor you are going against the market.

If Apple is 4% of the market, then your portfolio should contain 4% Apple. If it doesn’t you are going against the market, whether it is an expensive stock or not.

Where as everybody could have a market portfolio, not everyone could have a value portfolio. In fact that would be impossible. If someone holds a portfolio of value stocks, then somebody else must hold a portfolio of expensive stocks.

There are only so many stocks in the market place and they are all owned by somebody. Cheap stocks are only cheap when compared to expensive ones.

If everybody smart is investing in value stocks because they are such good investments then who is investing in expensive stocks?

At the end of the day, 50% of the stocks are expensive and 50% of the stocks are cheap. Do we really believe that 50% of the market is stupid when 95% of trades are being carried out by institutions.

There aren’t many people who can’t see the logic in buying cheap and selling expensive, but therein lies the problem. If everybody can see the logic and everybody knows about it, you have to ask yourself a couple of questions?

1. Who is selling these cheap stocks if they are so good?

2. Why are they so cheap?

We’ve already established that the answer to question 1 is the institutions with all their resources. As for question 2, cheap stocks aren’t going to be cheap without reason. Whether that be rapidly declining profits, rapidly increasing competition, mismanagement or something else, there has to be a reason.

Similarly, expensive stocks won’t be expensive without an explanation. This may be down to exceptional recent growth, great products, excellent management, great future prospects or all of the above. Whatever the cause, there will be some justification.

As far as I am concerned, the expensive stocks are expensive because the market expectation is that they are worth it and are likely to go up. The cheap stocks are cheap because the market expectation is that they aren’t worth much and are likely to go down.

Those in favour of the value approach will point to historic data showing that if you’d bought value stocks in the past they would have outperformed the market. That may be the case, but the point is, that not everybody knew about it before. Now, everybody knows!

In a perfect world, we’d all just buy cheap stocks and then sell them when they’ve become expensive. Unfortunately, it’s not a perfect world.

………and that’s why I take a passive approach and go with the market.

You can read more on a passive approach to investing here.