Why investing only in passive equities is not a good idea

Walk through any airport and you'll see dozens of books offering investment advice to the layman.

I've recommended my fair share of books to people too, people who are not from the industry, but who are smart enough to know that cash sitting in the bank account does not prepare you well to fund your children's education, retirement, unexpected shocks, etc.

I've always advocated that we should all have a "number" we strive for: a personal net wealth number which allows us to generate sufficient income to:

1. Cover periodic financial responsibilities (e.g. supporting extended family);
2. Cover unexpected "large" one-off expenditures;
3. Cover any financial obligations you may have (debts) with a buffer;
4. Cover you in case of loss of regular income (job);
5. Provide for your family's future needs;

To achieve these goals, your "number" needs to have certain characteristics:

1. It has to be resilient against economic shocks (e.g. inflation);
2. It has to be enough to give you comfort that you can cover all expected and UNEXPECTED expenses in the future;
3. It has to work FOR YOU: it has to generate enough passive income to allow you to sustain the lifestyle you chose for yourself, your family, etc.
4. It has to allow you to live “debt free” or at least with a “comfortable” level of debt;
5. It has to be achievable within a reasonable period of time: ideally before you reach the age of 50 and your energy drops dramatically;
6. It has to be something you can monitor and develop multiple ways to get to it (not just your daily job, but your investment plans and alternative sources of income).

As I mentioned earlier, many "investment" books steer people towards "passive equities" as a means to protect & growth their wealth.

On the surface of it, there is nothing wrong with this approach: it has worked remarkably well for decades.

A number often circulated is: the S&P 500 has returned around 8% p.a. since the early 1970s. So if you're investing "long-term", you can "reliably grow your portfolio at an average of 8%" as long as you hold long enough.

But, not so fast... this number is very misleading for 3 primary reasons:

1. It doesn't adjust for inflation

A dollar in 1980 is worth a LOT more than a dollar today.

Here is the decline of the value of the US$ in 2020 & what it's worth:

• $1 2020 = $0.67 2000, a drop of 33%
• $1 2020 = $0.51 1990, a drop of 49%
• $1 2020 = $0.32 1990, a drop of 68%

Here is a chart of the 30-year performance of the S&P500 NOT adjusting for inflation:

And here it the same chart, ADJUSTED for inflation:

Some examples of how this impacts you:

Suppose you invested in Jan of 2002 (towards the end of the tech crash):

• Without adjusting for inflation: you break even in Jan of 2004 (so it took you 2 years to recover your money, and then it starts growing from there);
• If you adjust for inflation: you break even in Jan of 2006! So for 4 years, you've made 0!

Why don't we look at the overall return of the S&P500 over the 30-year period (1990-2020):

• Not inflation adjusted: 8.5%
• Inflation adjusted: 4.4%

See the difference? So yes, you may have averaged 8.5% return over a 30-year period, but given that you get hit by inflation almost every year (your dollar is worth less year on year), you "actually" only made 4.4% per year in terms of "real purchasing power".

Furthermore, many economist criticise the inflation rates published by the Fed: saying that the published number underreports true inflation. If that's the case, then the return would be even less than 4.4%.

Now to the second reason:

2. Transaction costs

The returns I mentioned above (pre and post inflation adjustment) do NOT factor in transaction costs!

The returns (pre and post inflation) are for the S&P500.

But as an investor, you incur regular costs to purchase & sell the index (either through ETF or passive equity funds).

Every time you make a purchase or sale, you incur a transaction cost (commissions, fees, etc).

These vary so much that I won't get into attempting to calculate them, but for the sake of argument, let's assume a (low) annual cost of 0.5%.

This means that now your "true" annual return on the S&P500 as an actual "retail" investor over a 30-year period is 3.9% (4.4% less 0.5%).

3. Time of entry

The main argument about long-term equity holdings is: timing doesn't matter, performance will average out over time.

While this may have been true for a long time, you have to realise one important factor:

People who have made or lost money in markets over the past 20 years have done so because of (i) sudden and (ii) extreme market movements.

Look at the chart on the right: compare the volatility in the market 1975-1995 vs. 1995-2020.

Can you spot the difference? Markets since 1995 have been much more volatile.

Here are some data points (inflation adjusted):

• If you invested in mid-1997, with a view to hold long-term, you were still in the same place in 2011, 14 years later.
• Your average annual return 2010-2020: 8%
• Your average annual return 2000-2020? 2.8%!!

So yes, holding long-term may have worked if you were to look at 50-60-year data. But if you look at modern times, this hasn't been the case.

Again, the main reason for that: market shocks (up or down) and increased volatility. You can attribute that to globalisation, tech disruption (etc), but the bottom line is: higher volatility doesn't bode well for "passive" investments.

So what to do?

This article is already getting too long. I will soon write a separate post on tools available for portfolio optimisation.

Tony

Chart source: macrotrends.net