Funny how things change.
If you go back to 2015–2017, the biggest fad in finance was to open an account at Vanguard. com, throw a few thousand bucks in it, and stick it in index funds. This is how Vanguard accumulated many trillions of assets very rapidly.
Vanguard’s assets under management are still growing, but not as quickly. These days, people are shoveling money into Robinhood accounts and buying Tesla (TSLA), SPACs, and crypto.
- From a personal finance standpoint, this is undesirable.
I’m not the biggest fan of indexing. But the nice thing about people investing in index funds at Vanguard is that they’re more likely to keep those holdings longer term. Part of that is due to the open-end structure, as opposed to ETFs, where active trading is more common.
But underlying this is a pervasive belief that people can beat the market.
That sure seems easy when TSLA returns 1,000% in a year. And there are brief periods in history when beating the market is easier.
We are even seeing a surge in hedge fund returns as value stocks begin to outperform. I saw some year-to-date ranked returns of hedge funds the other day, and they truly are astounding.
I was very pessimistic about this a few years ago. When passive strategies reached 50% of assets under management (AUM), I figured the trend would continue until passive reached a much larger percentage of AUM, like in Japan.
But it hasn’t worked out that way.
In fact, the point in which people were freaking out the most about passive ended up being the best time to dive back into active management (around the time of the “Passive Investing is Worse Than Marxism” report from Bernstein & Co. in mid-2016).
Funny how that works.
One of my frequent criticisms of passive investing is the idea that people look at returns to the exclusion of all else.
Yes, it is true that passive outperforms active over time. And that outperformance is not insignificant. But investing in passive funds gives you no way to mitigate risk.
- When you invest in an index, you not only get the return of the index. You also get the volatility of the index.
Active managers can do a lot of things to mitigate volatility.
First of all, they can hold more in cash. They aren’t doing that right now (because it’s a bull market), but they can. They can also construct a portfolio that gains from disorder, resulting in less downside volatility. In CFA terms, this is known as the Sortino ratio.
But if you’re 100% in passively managed funds and a correction hits, you pretty much have to take it on the chin.
- The trick is to find the right actively managed funds.
Most average investors don’t have the ability to evaluate portfolio managers on this basis, and that’s the problem. I’ll tell you what I do—I pull up the latest 13F and look at the portfolio. You can tell pretty quickly if it’s a smart portfolio or a dumb portfolio.
Or, you can build your own portfolio, which retail investors also do not have a lot of experience with. To be reasonably diversified, you should have 20 stocks are more. That means you should probably have $100,000 in your account, with 20 $5,000 positions, in order to achieve sufficient diversification.
Most of the people at Robinhood don’t have $100,000 in their accounts. They are highly exposed to idiosyncratic risk.
Which is what they want, actually.
This brings us to the overall point: that people are in the mood to take risks.
Averaging 8% a year doesn’t sound so sexy these days. I saw recently that people’s return assumptions for the stock market have risen to 15%, the highest in the world.
The stock market may return 15% a year for a few years. But I assure you that it will not average 15% over anyone’s investing career, absent a large inflationary shock. (Which won’t come as a shock to your portfolio if you’ve read my inflation report.)
People are also not much in the mood to invest in bonds. I get it. It seems like we’re going to have lots of inflation, and the risk-reducing characteristics of bonds have deteriorated. But you still have to have some.
When people call the show and ask how to get started investing, I still direct them to Vanguard, but I qualify that by saying that there will be a point in their investing career when they outgrow Vanguard. It happened to me; it happens to everyone.
Speaking of which, we’ve all spent so much time in darkness and isolation… let’s go party! I’m throwing a party for subscribers on Friday, June 25, which is coming up fast.
There will be a lot of emotion in that room that night and many good vibes and smiling faces. I’ll include a link for tickets in the coming weeks. Come out, listen to some great music, and meet fellow subscribers. It is going to be epic.