I recently began watching HBO’s The Wire for the first time. I’ve been told by many friends that it’s a great show. I’m only about half way through season one, so while I can’t speak to its quality yet, I do have some thoughts about a quote from the show I came across:
“You cannot lose, if you do not play.”
This got me thinking of an exchange I had with Jeffrey Ptak via Twitter on Friday.
I highly recommend Jeffrey’s post, “Consistency is a Mirage”, which discusses the merits of judging active management on its persistency. He makes a great case for why this is not a good way to measure active management’s success or failure. However, he noted in the post that he has, “gone on record numerous times to say that most people should use passive, not active, funds”. You can see my follow up question below along with Jeffrey’s response:
@BrendanMullooly putting taxable money aside (it s/b indexed), yes. Cost and behavior of impulsive investors and PMs alike. Tough to succeed
— Jeffrey Ptak (@syouth1) October 28, 2016
Aside from the cost and the potentially higher tax implications of most active strategies (two very big things you should not overlook), I think another, less discussed, reason for most investors to index is their inability to deal with tracking error. Jeffrey shows in his post that the very best active strategies have returns that are lumpier than the already lumpy returns of stock indexes. If an investor, advisor, or portfolio manager isn’t patient enough to see a proven active strategy through its inevitable underperformance relative to market benchmarks, they shouldn’t even think about tying up money with it.
“The great strategy that you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
I cannot stress this point enough. While there’s plenty of research showing that a market capitalization weighted index can be bettered by different strategies, if an investor is not there to realize the outperformance, does it matter? Only informed believers of any active approach should be willing to invest in it. Unfortunately, we see many investors (and advisors) who join in the performance chase without stopping to remember that recent outperformance will eventually ebb into underperformance if the strategy is truly active. You have to be present when the outperformance occurs for it to mean anything to you, so unless you have a crystal ball, that’s going to mean being present for underperformance as well.
Many people obsess about beating market benchmarks. Usually, by doing so they hop from strategy to strategy in a futile attempt to achieve success. They’d be better off taking The Wire’s quote to heart: “You cannot lose, if you do not play”. Unless you’re willing to underperform at times, you’re probably better off not playing the active game and just indexing your portfolio. You’ll never outperform the index, but you’ll also never dramatically underperform it. If that helps you stick with your investments, then you’ll probably be better off.