Investing's Active-Passive Tug of War

Aug. 29, 2013 -- In investing, as in most endeavors, there's the ideal world and the real world. Ideal-world investing is for theories, while real-world investing is for real people.

Perhaps nowhere is this contrast more evident than in the classic debate over which type of asset management is better: active or passive. Active management relies on fundamental and technical analysis to determine what and when to buy and sell – or whether to be invested at all. Passive management involves capturing returns (both negative and positive) from slices of the market, usually by buying shares in index funds, which own the same stocks as those that make up the major indexes, such as the S&P 500.

The perennial debate over which of type of investing is better is as intense as the bickering between Democrats and Republicans. Advisors in the two financial camps tout market studies supporting their views while individual investors look on haplessly, bewildered by the opposing arguments.

To support their case, passive management people (indexers) point to studies indicating superior long-term aggregate returns. Many of these studies seem to be scientific and make sense mathematically. But, in many cases, they may be moot because they concern investment returns, not investor returns. The two are different.

For set periods, these studies cite investment returns — what given holdings would pay if you bought in at the beginning of the period studied. Investor returns are what real people actually earn during the periods that they actually own these same investments. Often, investor returns are far lower than investment returns because of what investment analysts call sub-optimal (i.e., human) behavior.

Nevertheless, passive management advocates recommend, just hang in there with index funds when they plummet and you'll do fine in the long run. This is great in theory, but in practice, this approach doesn't account for the human element. Especially for retired investors that are depending on their portfolio. Too many just can't stand the hemorrhaging, because they know that a 50 percent loss could mean having to go back to work. After losing too much of their life's savings when markets plummet, they typically sell low — after suffering a lot of damage. For those in or close to retirement, the pain from a tanking market — and tanking indexes — is especially excruciating. Many of them may not live long enough to see their investments come back.

When the entire market is tanking, one thing these investors can do is to get out early in the slide, take a time-out and wait to get back in the game. Many times, before the entire market suffers a major downturn, some individual stocks begin to sell off. If you have a portfolio of 20-30 stocks, you might consider setting a stop-loss on each of them at a set amount — say, 10 percent. By the time the entire market begins to crash, you may find that you've already sold a number of the holdings using your stop-loss limit.

Passive management advocates sometimes inaccurately call this practice market timing (the risky practice of investing based on predictions of the market's direction), but it's actually a form of risk management. Market timing is when investors buy or sell in anticipation of a market change. By contrast, you use a stop-loss not to time the market, but in the event that stocks you own actually begin to drop. It's not speculation. Rather, it acts as a form of loss insurance.

Of course, passive management adherents don't believe in keeping a sharp eye on the market horizon for significant shifts because they wouldn't do anything about these signals anyway. But for those who prefer to act, it's a good idea to keep an eye on money flows in and out of specific stocks. When money's flowing out of a stock, there are more sellers than buyers, and many times that doesn't bode well for its price. When there are more buyers than sellers, especially when the price increase is on large volume, this could be a sign that big institutional investors are accumulating shares of the company and that demand will likely lead the stock higher.

During some periods, money flows can indicate changes in parts of the market that are positive compared with the overall market, or vice versa. For example, in late July, the Nasdaq was attempting to reclaim a leadership role as it had higher inflows while the S&P suffered after low inflows. The passive management credo includes a belief in the buy-and-hold philosophy of investing. They believe that once they set up a sound asset allocation, all they need to do is maintain that allocation through periodic rebalancing and they'll be fine, because market upturns will more than compensate for downturns over time.

The buy-and-hold crowd typically adopts formulaic asset allocations that have been around for generations but no longer tend to make sense. This worked fine as long as certain assumptions held true. For example, for someone with an average risk tolerance approaching retirement, the classic allocation formula calls for a hefty allocation to bonds, around 40 to 60 percent. From the early 1980s until recently, this bond allocation worked out great as interest rates peaked and began to decline. Now, these rates are so low that there's almost nowhere for them to go but up with inflation (also quite low historically).

But when interest rates begin to rise, bonds could be a significant drag on your portfolio. If you're 55 years old and accept the bond allocation at face value and load up on 30-year bonds, your portfolio could be hurting when inflation and interest rates rise.

So instead of using a set-it-and-forget-it asset allocation, such investors are better off varying their allocations over time to reflect variable market conditions and changing risk.

Some people seek to justify the bond allocation by saying that the best use of bonds is not to gain returns, but to reduce risk and dampen portfolio volatility.

This dynamic was visible in 2008 in the Lehman Brothers Aggregate Bond Index (rebranded as Barclays Aggregate Bond Fund in November 2008), used to track bond market trends.

On September 12, 2008, a key exchange-traded fund (ETF) tracking this index, the iShares Aggregate Bond Fund (AGG), was trading at about $101 per share. A few weeks later, on October 10, 2008, it had dropped to around $88 per share. Thus, risk was hardly reduced.

Anyone loading up on bonds now to counteract market volatility might be disappointed when interest rates begin to rise, triggering bond declines.Bonds have a time and a place in most portfolios, but to just blindly allocate a large position without regard to the current economic outlook doesn't make sense – especially for those in retirement who, above all, want to avoid going back to work.

Using a buy-and-hold approach doesn't seem to make sense for stocks, either. The 2008–09 meltdown wiped out 10 years of gains for many investors, capping what has come to be known as the "lost decade."

In 2008, memories of tanking, volatile markets should have been fairly fresh for many investors because of the events early in that decade. From March 11, 2000, to October 9, 2002, the Nasdaq Composite lost 78 percent of its value, falling from 5046.86 to 1114.11.

In both 2008–09 and 2000–02, many people held on to declining stocks as long as possible, only to sell far too long into the slide for far too little.In such markets, you have a choice: Do you sit there and take the punishment because you expect the market to do right by you in the next 10 or 20 years? Or do you act strategically to limit the damage, preserve capital and live to fight another day?

Which style of investing is right for you? Well that depends on your risk tolerance, stage in life, investment knowledge and your experience (and your advisor's) and the goals of your investment portfolio.

I can't stand by and watch my portfolio drop, hoping to make it back over the next 20 years. Nor could I be happy owning a bunch of index funds that contain both the best-performing and worst-performing stocks.

In his best-seller How to Make Money in Stocks, legendary investor William J. O'Neil wrote: "Broad diversification is plainly and simply often a hedge for ignorance." I couldn't agree more.

This column is the opinion of the author and in no way reflects the opinion of ABC News.

Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard is listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.