Multi-Factor Design

The Active Dangers Of Passive Investing

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Multi-Factor Design

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This is part two of a three-part series. You can read part one here.

You can listen to this article here.

Investors are prone to two opposing but equally debilitating fears: the fear of missing out when times are good, and the fear of loss when markets are volatile. These two fears have a zero-sum relationship with rational decisions. The more you are dominated by these fears, the less rational you are.

So what can we do, as investors, to move toward maximum rationality? Here’s one piece of advice:

Don’t constantly watch your portfolio

Next time you notice the price of a stock you own moving up or down, think about the factors that may be influencing that move. Stocks are owned by people who have very different time horizons. You’ll have mutual funds and hedge funds whose clients often have the patience of five-year-olds. They are getting in and out of stocks based solely on what they expect them to do in the next month or six months – a rounding error of a time period in the life of a company that lasts decades.

Some buyers and sellers are not even humans but computer algorithms that are reacting to variables that have little or nothing to do with fundamentals of the company you invested in – these players have a time horizon of milliseconds.

You will also have folks who are buying and selling a stock based on the pattern of its chart. Not that they don’t know what the company does; they will tell you they don’t care what it does. For them it’s just a chart with one squiggly line crossing another squiggly line.

Then there are folks who spend more time researching the next movie they are going to see than the stock they’re about to buy. Some of them buy a stock after reading a single article on the internet, while many others buy on the advice of their brilliant neighbor Joe, the orthodontist.

The active dangers of passive investing

Deciding not to constantly look at your portfolio is not necessarily the same thing as embracing the latest craze – passive investing. This one is a bit personal and requires a small detour.

Interest rates are the foundation of the discount rate (also known as the required rate of return) that investors use to convert future cash flows into today’s dollars. Think of the discount rate as being composed of two layers: the foundational layer, or the risk-free rate (the interest rate, let’s say, on the 10-year Treasury); and a risky layer that should compensate you for additional, asset-specific risks.

During the great recession, when central banks artificially changed the price of money by buying trillions in government and corporate bonds, they made the Soviet planned economy look like child’s play. Instead of messing with kiddie stuff like setting prices on shoes and sugar like Soviet central planners did, a few dozen “free market” central bankers set the price of the single most important commodity, the risk-free rate, which is at the core of most economic decisions and the valuation of all assets.

Valuation of companies whose earnings lie far, far in the future benefits dramatically from falling interest rates, while the valuation of companies whose earnings are not growing as much and are concentrated in the present and near future doesn’t enjoy that benefit.

A similar dynamic happens in the bond market: Bonds with short maturities (similar to value stocks) are impacted a lot less by declining interest rates than long-term bonds (similar to growth stocks).

As the impact of suppressed interest rates rippled through the markets, active managers that had even a modicum of discipline in their stock selection found themselves trailing their benchmarks and even getting fired, while customer money flowed into index funds that indiscriminately buy what is in the index.

What is in the index, you may ask? Most popular indices today are constructed based on companies’ capitalization. Thus, companies that have done well lately (for example, the tech giant “FANGs”–Facebook, Apple, Netflix and Alphabet’s Google), get a much greater portion of new capital – in fact the FANGs account for about 10% of the S&P 500 Index. So “high-duration” companies are benefiting from both low interest rates and the “dumbness” of the indices.

Read the full article here by Vitaliy Katsenelson, Advisor Perspectives


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