VALUE: After Hours (S07 E40): The Passive Investing Problem No One Talks About: Hidden Risk

During their recent episode, Taylor, Carlisle, and Seth Cogswell discussed The Passive Investing Problem No One Talks About: Hidden Risk. Here’s an excerpt from the episode:

Seth: Yes. Which one matters more? I would argue that risk in the long run matters more, because that money matters. People have forgotten that risk matters, because we haven’t experienced a true downturn in 15 years. But when you need that money that you’ve worked so hard for and it’s not there, that is a whole lot worse than if you have more money than you needed.

And so, passive has somehow gotten away with completely overlooking risk. The only way that the passive narrative addresses risks is they say, “Eh, market goes up on average. You’ll be fine.” That’s absolutely ridiculous. What if you’re retiring in the next three years and we go through a lost decade, which the odds look pretty high of at the moment. You’re having to pull out money after a big drawdown which absolutely destroys your cumulative returns over the long run. There’s a lot of data points. There’s no arguing that.

The other thing is that’s conveniently overlooked is the behavior gap. I am not immune to making dumb decisions when I’m emotional. I’ve made plenty of stupid decisions. When we, as people, are stressed out, if we see our net worth drop 50%, we are inclined to panic and sell, because we don’t want to experience any more. So, yes, we’ve got the people who sold us passive, we’ve got the S&P saying, “Oh well, it’ll be okay. Just hold on.” Are you going to want to pile more in? No. And you might sell. And that destroys returns. So, conveniently, completely overlooking that also bothers me.

Sorry, I’m getting a lot long winded. I clearly am a little passionate about this. But the other thing that I recently had an epiphany on, is we’d have this active passive debate and everybody brings up the data, which I would argue as, henpecked as most data is, I don’t think a lot of it’s valid. But regardless, if you break passive into its simplest form, so if we just look at it on an individual stock basis. Again, we’re going to use Apple, because everybody knows it.

Apple is a company, it’s operating in the real world, it’s selling products, it is worth this amount of money. If it’s a private company, we would work with number of auditors to come up with a value that somebody would buy it for. It’s a company. It has a value. Now, the stock is driven by supply and demand. So, if there’s a lot of demand, it goes up. If a lot of people are selling, it goes down, whatever. It’s swinging around. Let’s say at one given point in time, we used to think the market was efficient, that many would argue that it’s just broken now. But regardless, let’s say at some point, the market is efficient.

The price of the stock is equal to the value of the company. Somebody bought an iMac, two months ago, they’re doing something on it, and they’re like, “Man, my iMac is the greatest. I love it.” And so, they turn around and they buy, let’s say, a million dollars of Apple. They’re pretty wealthy. Buy a million dollars Apple. That demand is going to push the price of Apple up. Again, nothing changed with regard to the company, because they bought that iMac months before. But now, the stock price is higher. Because the stock price is higher, it’s now a higher percentage of the S&P. And anybody that invests in the S&P from here on invests more in Apple, because it’s overvalued.

Then we were talking earlier about momentum. I can’t imagine how much money is in momentum strategy at this point. But regardless, a momentum manager says, “Hey, Apple’s flying. We need that.” And so, more is invested in Apple that’s going to push Apple up even further, that demand. So, now, because Apple is even more overvalued, it gets an even higher percentage of the S&P, which means that everybody invests in Apple now buys even more, because it’s overvalued. And that keeps going.

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