"Active" Index investing vs. "Passive" Index investing

[KlangFool]

I wonder how Buffett does it that makes him rich.

GoldenGoose,

Why do you need to wonder? If you believe in Warren Buffett, you could hire him to invest for you.


Just buy BRK.A and BRK.B


Aka, Warren Buffett's company.


KlangFool

[KlangFool]

OP,


This is personal finance. In order to start on this journey, we need to ask and define the goal.


For example,


A) The goal is to have 25X retirement expense in 20 years.


B) The annual saving rate is 1X retirement expense.


C) Calculate the return rate needed to reach the goal.


D) Implement the strategy to reach the goal. If that is not realistic, adjust (A) or (B).


So, if a person saves 1 year of retirement expense every year, why does the person need anything more than passive index investing?


If a person saves much less, what is the return rate needed to reach the goal? Is it realistic?

My question to you is what is your expected return rate for active investing? Is it realistic? Is it achievable?


If you could consistently return 20% per year, you could start your own hedge fund. You would be one of the best in the world.


KlangFool

[willthrill81]

If I need to explain "how do you know which ones?", then this approach is not for you. Recognizing these few performing stocks in the index takes time, effort, intuition and know-how.

Do you have more "time, effort, intuition and know-how" than the thousands of active managers out there who have been professionally trained to do it and attempted to do it for decades with most of them failing miserably?

[TheLaughingCow]

one can be passive and aggressive at the same time

I have known a few people like this

[Kelrex]

You're moving the goal posts.

First you come in here positing an approach, then you claim that you have knowledge and abilities that allow you to identify stronger companies to invest in, then people challenge that approach with pretty well thought out challenges, then you say that we're all basically programmed towards failure, which is why we won't consider anything other than indexing, then you switch to saying that you might beat the index or you might not, and never actually said that you could beat the index with your knowledge and abilities to pick stocks.

So now, what is your original point?

Is this all just to say that you feel like stock picking, and don't care what anyone thinks?

Okay cool, have fun stock picking.
I really don't understand what you are looking for from us???

My goal is to have a debate about investment theory. This is the board for it, isnt it? I do appreciate you guys for trying to poke holes in the theory. I was trying to defend the thesis (somebody has to). Again, not personal not confrontational, no ego. What disappointed me so far is no one could switch position to see if there are any merits from the pro side. Everyones concern seems to be losing to the index. And no, this is a buy and hold. No stock trading.

You're disappointed that you have so far failed to convince a lot of very, very intelligent people who have chosen passive investing after intensive investigation into the alternatives that they should consider active investing, after giving us zero compelling reason to see that your particular approach has a significant probability of beating the index???

Really???

You seem to assume that none of us have ever had the courage to even consider active investing. That we read one thing that told us that passive investing is safe and we're too afraid of loss to ever consider the possibility of seeking higher gains.

I'm sorry, but that message, which is very, very much how you are coming across is downright insulting to the population you are engaging.

If you are meaning to express something other than that, then by all means, I welcome you to clarify.

However, take a minute and imagine that everyone who is responding has actually already done this mental exercise and still concluded for themselves that indexing is likely to produce *superior* results. Not safer results, actually higher gains.

Consider that possibility, and now think about how your responses might sound to us.

ETA: if I personally were to seriously consider an approach other than indexing, I would likely go the opposite direction and engage in Taleb-style Black Swan investing. However, I do not have the time, energy, or particular skill necessary to pull that off. So instead, I index.

[vineviz]

What I find interesting in this thought excercise is the risk adverse nature of this board. Everyone who chimed in always has the specter of failure.

What you’re perceiving as risk aversion isn’t that: it’s wisdom, intelligence, and experience.

You’re proposing a gamble with a strongly negative expected return. You don’t have to be risk averse to think that’s a bad idea, just good at math.

[KlangFool]

You're moving the goal posts.

First you come in here positing an approach, then you claim that you have knowledge and abilities that allow you to identify stronger companies to invest in, then people challenge that approach with pretty well thought out challenges, then you say that we're all basically programmed towards failure, which is why we won't consider anything other than indexing, then you switch to saying that you might beat the index or you might not, and never actually said that you could beat the index with your knowledge and abilities to pick stocks.

So now, what is your original point?

Is this all just to say that you feel like stock picking, and don't care what anyone thinks?

Okay cool, have fun stock picking.
I really don't understand what you are looking for from us???

My goal is to have a debate about investment theory. This is the board for it, isnt it? I do appreciate you guys for trying to poke holes in the theory. I was trying to defend the thesis (somebody has to). Again, not personal not confrontational, no ego. What disappointed me so far is no one could switch position to see if there are any merits from the pro side. Everyones concern seems to be losing to the index. And no, this is a buy and hold. No stock trading.

You're disappointed that you have so far failed to convince a lot of very, very intelligent people who have chosen passive investing after intensive investigation into the alternatives that they should consider active investing, after giving us zero compelling reason to see that your particular approach has a significant probability of beating the index???

Really???

You seem to assume that none of us have ever had the courage to even consider active investing. That we read one thing that told us that passive investing is safe and we're too afraid of loss to ever consider the possibility of seeking higher gains.

I'm sorry, but that message, which is very, very much how you are coming across is downright insulting to the population you are engaging.

If you are meaning to express something other than that, then by all means, I welcome you to clarify.

However, take a minute and imagine that everyone who is responding has actually already done this mental exercise and still concluded for themselves that indexing is likely to produce *superior* results. Not safer results, actually higher gains.

Consider that possibility, and now think about how your responses might sound to us.

ETA: if I personally were to seriously consider an approach other than indexing, I would likely go the opposite direction and engage in Taleb-style Black Swan investing. However, I do not have the time, energy, or particular skill necessary to pull that off. So instead, I index.

+1,000.


I work in Telecom Industry. I gambled on the Telecom stocks and lost 50% of my whole life savings in the Telecom Bust.


My family member worked in the Wall Street. He was paid 7 figures in annual salary and bonuses. He lost 10 million in the Telecom Bust.


So, some of us had tried and failed. We paid heavily for this lesson.


KlangFool

[firebirdparts]

Your offer to side with you is intriguing. To respond as if it were a serious question, the world is full of people picking stocks. There are a billion people trying to figure out how to beat the market. Half the children are above average. What’s to discuss? Join them.

Having less money wouldn’t necessarily improve your stock picking ability. Using a lack of money as a justification for style is actually rational if you use it as a reason to take more compensated risk. It’s irrational if you use it as a reason to take uncompensated risk. However, I can see where you might define investing result as a binary financial outcome which is all that really matters, like I need a million, and half a million is no better than zero. That is a spectrum that ends with only five dollar and the idea that I “Might as well” Buy a lottery ticket.

So if for some reason you define the target as a binary target that you are sure you can’t reach by passive investing, then I think you have your justification. You have a chance of success. This is not a good plan; it is merely a plan with a chance of success.

[willthrill81]

This is not a good plan; it is merely a plan with a chance of success.

Bingo.

'Beating the market' is not a good goal and definitely not a plan. A good plan should specify precisely what will be done and should have a high probability of success.

[coachd50]

This is the BH forum where we want to do passive index investing because its safe.

I think this misunderstands Boglehead or index investing. It isn't a retreat to safety. It is an advance toward the best chance at good gains. Far more often than not, the return will be greater than stock picking.

Bingo!

I read so many posts here that seemed focused on trying to achieve the maximum possible numerical gain, or maximum net worth etc. That probably isn't the best way to look at it. What you stated should be the focus. The best CHANCE to have solid gains. In other words, maximizing the likelihood that your life after income earning years will be comfortable (or at least tolerable).


Because of pricing equilibriums, the only way to achieve above avg gains on anything is not only to be able to predict the future (or correctly guess the future) but to be in the minority of people who are successful at this task. And obviously, there is a great deal of uncertainty when it comes to investing in anything (individual securities, mutual funds, real estate, commodities, precious metals, artwork..etc).

What is very much certain for the vast majority of people is one will either:
A) Die while working for an income, making retirement and investment somewhat moot.
B) Stop being able to earn an income by working at some point and have to live off of another income stream.

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

[Regal 56]

What I find interesting in this thought excercise is the risk adverse nature of this board. Everyone who chimed in always has the specter of failure. If picking individual companies is impossible, then how has Buffett been doing it? No one on this board has answered this question. If he was a nobody posting on this board and talk about his successes in picking stocks/companies, I guess everyone would be saying "it was just dumb luck".

You’re citing an outlier and implying you could do as well. You overlook the huge number of committed investors who never replicate Buffett’s success.

I’m a musician. I could listen to Mozart and believe that I could do as well. But I’m more likely to fall short of Salieri.

[willthrill81]

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

You can definitely get 'rich' being a passive investor. You're just not going to get 'rich' quickly, nor is being a passive investor going to lead to outsized returns (e.g. +20% CAGR).

[willthrill81]

What I find interesting in this thought excercise is the risk adverse nature of this board. Everyone who chimed in always has the specter of failure. If picking individual companies is impossible, then how has Buffett been doing it? No one on this board has answered this question. If he was a nobody posting on this board and talk about his successes in picking stocks/companies, I guess everyone would be saying "it was just dumb luck".

You’re citing an outlier and implying you could do as well. You overlook the huge number of committed investors who never replicate Buffett’s success.

I’m a musician. I could listen to Mozart and believe that I could do as well. But I’m more likely to end up as Salieri.

Even Buffett's success has been in the rearview mirror for quite a while. VTSAX has outperformed BRK since 2002.

[coachd50]

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

You can definitely get 'rich' being a passive investor. You're just not going to get 'rich' quickly, nor is being a passive investor going to lead to outsized returns (e.g. +20% CAGR).

I agree. I guess it is more accurate to state that as a passive investor, the primary driver of wealth for the majority, if not vast majority of your years will be the income from work, and the biggest factor in the investment gains will be the % of that work income you are able to invest.

In the OPs initial scenario, (person can't invest until they are 45 years old) it seems like his premise is to "get rich quick".

[Kelrex]

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

You can definitely get 'rich' being a passive investor. You're just not going to get 'rich' quickly, nor is being a passive investor going to lead to outsized returns (e.g. +20% CAGR).

I agree. I guess it is more accurate to state that as a passive investor, the primary driver of wealth for the majority, if not vast majority of your years will be the income from work, and the biggest factor in the investment gains will be the % of that work income you are able to invest.

In the OPs initial scenario, (person can't invest until they are 45 years old) it seems like his premise is to "get rich quick".

But again, I question how his approach would actually get him rich quick when it's guaranteed to miss out on a lot of explosive growth companies.

I understand taking more risks to make more quicker, I just don't understand how this proposed approach would accomplish that??

[willthrill81]

In the OPs initial scenario, (person can't invest until they are 45 years old) it seems like his premise is to "get rich quick".

Yes, that appears to be a common reaction among those who realize that they are way behind with their savings and try to compensate by stock picking, going in for lots of leverage, etc. That might work, but the likelihood of success is relatively low. The better approach is to find ways to (1) decrease spending and (2) increase saving. As Pete the Planner pointed out in a short podcast series a year or two ago, those who haven't saved anything by age 50 are not at all sunk financially, but they do need to make some significant changes to their behavior. SS will form the bedrock of many retirees' plans, and if that is combined with owning a home outright by the time of retirement and not having to financially provide for children anymore, those who haven't saved anything by age 50 can potentially have a really good shot at a nice retirement, especially if they can augment all of that with good savings for 15-20 years.

[whereskyle]

I wonder how Buffett does it that makes him rich.

There is no comparison., Buffet is not a small investor buying stocks. Buffet is the CEO of a large company with a staff of analysts to do his research. He doesn't buy stocks, he buys controlling interest in entire companies and large stakes in even larger companies. The companies in which he invests open their books to him, allow him to meet with the management team, and otherwise give him advantages that you will never have.

Of course he has to do DD on the companies he was going to buy right? Buying a bad company is just like buying a bad stock. Given his current position I agree. He has more advantages than we have. So unfair. But not to say he didnt make big mistakes or that he did not speculate at one time like we are doing now. My point is he didnt get rich by buying index funds. He took risks and "luckily" reaped the rewards.

Didn't he also buy large enough stakes to influence how the companies operated going forward?

I am not sure but I still remember back in 2008 he got an extremely sweet deal with GS. For his 5 billions invested in GS preferred shares (not common shares we common folks can only get), he gets 10% interest annually plus warrants to buy millions more shares of GS at that time period price. He made out like a bandit because of his unfair clout.

And because you have nothing resembling his clout, you should probably do what he thinks you should do, which is buy the SP 500 index (although I prefer total-market solutions).

If you're not yet sure, be now sure. Warren Buffett is not a stockpicker. He is a businessman. Controlling the way the business operates is his forté and is the reason he has the clout you reference.

You should not use Warren Buffett as a reason to try stockpicking. He has repeatedly told Berkshire Hathaway shareholders that it is his preference to buy a controlling share, if not the whole business, of any company he invests in. If he doesn't buy the whole thing all at once, he likely enters with the intent to do so later.

If you're not a businessman, Buffett has advice for you. Buy an SP 500 index fund, preferably the very-low-cost one managed by Vanguard.

[coachd50]

My goal is to have a debate about investment theory. This is the board for it, isnt it? I do appreciate you guys for trying to poke holes in the theory. I was trying to defend the thesis (somebody has to). Again, not personal not confrontational, no ego. What disappointed me so far is no one could switch position to see if there are any merits from the pro side. Everyones concern seems to be losing to the index. And no, this is a buy and hold. No stock trading.

I believe the quest for the "merits" of individual stock picking have already been flushed out in numerous scholarly articles that all point to the fact that over the long hall the best percentage play is to invest in a low cost (key point, as expenses drag returns) fund that tracks a broad based or total market index. So there probably isn't much debate to have on that topic.

You keep talking about "risk and safety" but what you seemingly fail to release is that the "risk" is actually an increased chance of suboptimal or sub market returns, not just the risk of losing money in a market downturn. Put another way with made up figures- Lets say the person in your original post can invest $20,000 a year for those 20 years. Numerous studies have shown that it is more likely that the portfolio would total say $750,000 (minus taxes) at the end of those 20 years if the person just invested in low cost total market index funds than by investing the $20,000 as you suggest. That is the "risk" that you seem to gloss over. It isn't necessarily that they would have less than $400,000 in the nest egg by doing what you suggest, but rather it is more likely they would have less than the $750,000.

Put in real terms, that extra $$$ ($10,000, $30,000, $100,000 who knows) is paying for the persons bills after they no longer produce income. That is a real risk.

Now, the same person could put the initial $400,000 in a passbook savings account, and then right before retirement go to the casino, bet it all on red or black or odd or even on an American roulette wheel and have an 46.37% chance of having $800,000 (minus taxes). Or a 53.63% chance of having nothing. They could let it ride (or choose another bet) and then have about a 21% chance of having $1.6 million (minus taxes), but obviously that is a 79% chance of having nothing. That is more extreme, but I think it also highlights the issue more clearly.

[coachd50]

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

You can definitely get 'rich' being a passive investor. You're just not going to get 'rich' quickly, nor is being a passive investor going to lead to outsized returns (e.g. +20% CAGR).

I agree. I guess it is more accurate to state that as a passive investor, the primary driver of wealth for the majority, if not vast majority of your years will be the income from work, and the biggest factor in the investment gains will be the % of that work income you are able to invest.

In the OPs initial scenario, (person can't invest until they are 45 years old) it seems like his premise is to "get rich quick".

But again, I question how his approach would actually get him rich quick when it's guaranteed to miss out on a lot of explosive growth companies.

I understand taking more risks to make more quicker, I just don't understand how this proposed approach would accomplish that??

My opinion, I don't think it will. I think the OP is demonstrating a lack of understanding of many investing and financial concepts, as well as some mathematical ones here as well.

[nydoc]

I am so moved by this novel idea and can’t wait for coming Tuesday to move all my index funds to golden ticket stocks. Wonder how did I not realize this sooner?

[alex_686]

The point here is that somebody starting out late with not much of a stake has a low ability to take on risk. You may not be able to hazard much risk.

This is from your own personal perspective. Others might think differently. That's why you do index while others do daytrading. You can't make blanket assumptions.

This is my professional opinion, not my personal perspective. This type of stuff is my day job. If you have X dollars today, and need Y dollars in Z years one can quantify the ability to take risks. Sure we may noodle around with some of the inputs. But anyway you slice it, the lower amount you have today the lower your ability is.

[Doctor Rhythm]

If you ever took a look at the investment chart of risk vs return you would see that the higher the return the more risk involved. If you want a guarantee of a fixed return, why don't you invest in CD? Oh you want a higher return but with a bit more risk? There is bonds. Not satisfied with that return? How about index fund? Still not satisfied? Active investing? Still not content? Daytrading or starting a business. Not everyone failed at daytrading, right?

I’m not sure you understand risk and rewards in the same way it’s usually discussed on this forum. Stocks are riskier than bonds and CDs as evidenced by the wider standard deviation around their average returns. However, for most people it’s worth investing in stocks because their expected average return is higher than for bonds. This is described as a compensated risk.

Picking individual stocks produces an even wider standard deviation than buying the total market, so it is described as being more risky. However, empiric evidence and the zero sum game hypothesis suggest that stock picking cannot produce an expected average return better than the total market. In other words, your chances of beating the market aren’t better than that of the market beating you. This is therefore uncompensated risk - which we try to avoid when investing but embrace when gambling.

Now, if someone has an advantage that makes their stock picking ability better than average, the risk might be compensated. I’m guessing that anyone who posts on this board doesn’t fit in that category even if they think they do.

[hagridshut]

It seems too many people are so conditioned to failure so the only question asked is what if the return is lower than the index. What about what if the return is higher than the index? Isn't that a potentiality? Has anyone done this before to definitively say it doesn't work?

Some selective stock picking can IMO can boost portfolio CAGR significantly, but this is not a path I recommend for most people. It is often a mentally and psychologically punishing experience. Even if you win in the end, the gains are often not "free" because of the time and stress involved.

I've outlined my reasoning in detail here: viewtopic.php?p=5539351#p5539351.

Some wisdom is required. For people who know that they have high risk tolerance and resistance to emotional trading, an active approach may work. However, my observation is that most people cannot handle it and should stick to index funds. Perhaps it might work to experiment with some disposable income, but it make take 5-10 years to determine if one really has what it takes to invest in individual companies.

[coachd50]

It seems too many people are so conditioned to failure so the only question asked is what if the return is lower than the index. What about what if the return is higher than the index? Isn't that a potentiality? Has anyone done this before to definitively say it doesn't work?

Some selective stock picking can IMO can boost portfolio CAGR significantly, but this is not a path I recommend for most people. It is often a mentally and psychologically punishing experience. Even if you win in the end, the gains are often not "free" because of the time and stress involved.

I've outlined my reasoning in detail here: viewtopic.php?p=5539351#p5539351.

Some wisdom is required. For people who know that they have high risk tolerance and resistance to emotional trading, an active approach may work. However, my observation is that most people cannot handle it and should stick to index funds. Perhaps it might work to experiment with some disposable income, but it make take 5-10 years to determine if one really has what it takes to invest in individual companies.

How do you ensure the "selective stocks" are winners?

[willthrill81]

It seems too many people are so conditioned to failure so the only question asked is what if the return is lower than the index. What about what if the return is higher than the index? Isn't that a potentiality? Has anyone done this before to definitively say it doesn't work?

Some selective stock picking can IMO can boost portfolio CAGR significantly, but this is not a path I recommend for most people. It is often a mentally and psychologically punishing experience. Even if you win in the end, the gains are often not "free" because of the time and stress involved.

I've outlined my reasoning in detail here: viewtopic.php?p=5539351#p5539351.

Some wisdom is required. For people who know that they have high risk tolerance and resistance to emotional trading, an active approach may work. However, my observation is that most people cannot handle it and should stick to index funds. Perhaps it might work to experiment with some disposable income, but it make take 5-10 years to determine if one really has what it takes to invest in individual companies.

How do you ensure the "selective stocks" are winners?

Apparently, if you have to ask that question, the answer is you cannot.

If I need to explain "how do you know which ones?", then this approach is not for you. Recognizing these few performing stocks in the index takes time, effort, intuition and know-how.

[hagridshut]

It seems too many people are so conditioned to failure so the only question asked is what if the return is lower than the index. What about what if the return is higher than the index? Isn't that a potentiality? Has anyone done this before to definitively say it doesn't work?

Some selective stock picking can IMO can boost portfolio CAGR significantly, but this is not a path I recommend for most people. It is often a mentally and psychologically punishing experience. Even if you win in the end, the gains are often not "free" because of the time and stress involved.

I've outlined my reasoning in detail here: viewtopic.php?p=5539351#p5539351.

Some wisdom is required. For people who know that they have high risk tolerance and resistance to emotional trading, an active approach may work. However, my observation is that most people cannot handle it and should stick to index funds. Perhaps it might work to experiment with some disposable income, but it make take 5-10 years to determine if one really has what it takes to invest in individual companies.

How do you ensure the "selective stocks" are winners?

You can't. Nothing is ever 100% guaranteed. Stock picking is still subject to the "fog of war", where nobody has a complete picture of what is going on, all the time. Having specialized knowledge and a high level of mental strength increases the chances of success, but never guarantees it.

This is why my recommendation is for people to build an index fund nest egg for securing a base level of retirement, before engaging in optional speculative activities with disposable income, should they feel inclined. The consequences of failure in individual stocks are much less severe if one has a solid base of Index Funds as fallback.

[RJC]

Yes (S&P 500 or TSM). The chances of either underperforming or stagnating for a long period of time is not impossible but is least risky compared to other stock options.

Ah, risk vs reward.

Least risky yet also gives you consistently solid returns.

[LookingForward]

OP, if you’re serious about this as a fact-based proposition, then do the experiment.

Take half of your portfolio and put it in whatever index fund you would be investing in, if you were purely “passive”, and then use your “pick the best” method on the other half of your portfolio. Pick a time frame that you think is fair, like 1 year or something, but make it a firm deadline.

At the end of the deadline, if your method hasn’t beaten the index, accept the result and don’t double-down on failure.

If, however, you beat the index, you’re free to go all-in. Please post your results.

[barneycat]

It seems too many people are so conditioned to failure so the only question asked is what if the return is lower than the index. What about what if the return is higher than the index? Isn't that a potentiality? Has anyone done this before to definitively say it doesn't work?

Despite your assertions to the contrary, your idea is not in any way meaningfully different from the active investing that thousands of fund managers attempt year after year. Clearly, it does work for some of them, at least for some period of time. However the number of them that are able to out-perform their index for 20 years is astonishingly close to zero.

There is an earlier reply by someone on this thread saying that comparing what I am proposing to active mutual funds managers are like comparing apples to oranges.

Which is patently ridiculous. You really think “pick only the best companies” is a novel idea?

I wonder how Buffett does it that makes him rich.

I know I'm late to this thread, but here is my two cents.

Listen to Swedroe's "Evidence of Shrinking Alpha." He makes a compelling case that the sources of alpha (beating the market) are being discovered one by one. He uses Buffet as an example: much of his out performance in the past can be explained by factors that we're now aware of and are used as investing strategies. This makes intuitive sense because, now that those factors are widely known, he has not outperformed the market. That by no means takes away from Buffet's genius, because he discovered the secret sauce decades before academics. But it does take away from using that past performance to indicate future out performance is possible.

Also, I saw a couple posts where you asked if this is truly the board for a debate. It surely is. If you're questioning that I think you should turn the mirror around and ask if you entered in this discussion from a position of intellectual honesty. If you're looking for people to validate your thoughts, this isn't the place. If you're looking for a true debate, introduce some evidence that this approach could work. The people here aren't commenting from a position of fear, from ignorance, or from some odd cult persona. They're commenting from a position after carefully considering decades of academic research that points out, quite definitively, that your approach doesn't work in a statistically significant manner.

Sure, you could do this and you might find success for a while or even forever. But that is unlikely and would be through dumb luck. Serious people don't make investing strategies based off of luck or hope.

There are some investing fundamentals that I think you need to go over again. Then engage in such a debate.

[willthrill81]

This is why my recommendation is for people to build an index fund nest egg for securing a base level of retirement, before engaging in optional speculative activities with disposable income, should they feel inclined. The consequences of failure in individual stocks are much less severe if one has a solid base of Index Funds as fallback.

Precisely. That's why HedgeFundie only used 'surplus' funds for his 'excellent adventure' strategy and recommended that others do the same, and that strategy seems less speculative to me than stock picking.

[BogleFan510]

I believe all John Bogle was advocating for was a method to make "B" above more achievable and more pleasant. Not a strategy to get rich.

You can definitely get 'rich' being a passive investor. You're just not going to get 'rich' quickly, nor is being a passive investor going to lead to outsized returns (e.g. +20% CAGR).

This is not necessarily true. Outsized returns are very possible, just not probable.

I think active is a bad word, as buy and hold is best for both individual stocks and index funds.

A few thoughts. One shouldnt pick stocks, they should, if anything, try to pick companies and management teams. When I hear someone say pick stocks, I think oh boy, they are in trouble. They are reading trashy news like Fool and thinking that is research.

Personally, my individual stocks have way outperformed my indexes, 20%+ is about right. However, when I picked these companies my job was one directly involved with fortune 500 companies, one where I was meeting CEOs/CFOs/CIOs on a regular basis, running knowledge sharing forums, diving deep into companies and industry finances, attending industry trade shows, and I had access to all the top research on technology trends (proprietary stuff). I was still wrong more often then right, and I was prevented from owning many due to ethics, because they were clients.

That said, I always had 80% of my investments in index funds anyway. There is no need to take crazy risk if you have a good salary and just want a normal level of lifestyle. Index stocks are just the best bang for the buck. Indexes also encourage proper buy and hold investing, while individual stocks dont. Individual stock huge gains tend to encourage profit taking, not more holding. My worst 'active' mistakes were writing covered calls on my long term held stocks to 'lock in' growth. I lost 7 figures of upside on a low 5 figures investment, and high 6 figures on a low 4 figures holding, doing this with 2 different stocks I should still have 7 figure positions in. I had held each 10+ yrs (believing in their solid growth prospects and margins).

[Regal 56]

This is why my recommendation is for people to build an index fund nest egg for securing a base level of retirement, before engaging in optional speculative activities with disposable income, should they feel inclined. The consequences of failure in individual stocks are much less severe if one has a solid base of Index Funds as fallback.

Bingo!

When someone posits a risky investing strategy, here’s a question they often gloss over: Can I afford to fail?

Higher risk is okay for things in which the price of failure is low. If I put $1,000 on red at a roulette wheel, losing won’t ruin me. I can bounce back from the loss. But in retirement investing, I’m contemplating whether I’ll be able to pay my bills when I can no longer earn a paycheck. At that point, there’s no bouncing back from a failed investment strategy. I can’t afford to fail, because I can’t start over at age 70. So I’m not willing expose my twilight years to significant risk.

Index investing, of course, has some risk. But it’s more akin to the risk that I’ll get hit by lightning—it’s not significant enough to keep me awake at night.

I believe a lot of people don’t distinguish between investing and gambling. Sensible people don’t gamble with their retirement. The price of failure is too damned high.

[coachd50]

This is why my recommendation is for people to build an index fund nest egg for securing a base level of retirement, before engaging in optional speculative activities with disposable income, should they feel inclined. The consequences of failure in individual stocks are much less severe if one has a solid base of Index Funds as fallback.

Bingo!

When someone posits a risky investing strategy, here’s a question they often gloss over: Can I afford to fail?

Higher risk is okay for things in which the price of failure is low. If I put $1,000 on red at a roulette wheel, losing won’t ruin me. I can bounce back from the loss. But in retirement investing, I’m contemplating whether I’ll be able to pay my bills when I can no longer earn a paycheck. At that point, there’s no bouncing back from a failed investment strategy. I can’t afford to fail, because I can’t start over at age 70. So I’m not willing expose my twilight years to significant risk.

Index investing, of course, has some risk. But it’s more akin to the risk that I’ll get hit by lightning—it’s not significant enough to keep me awake at night.

I believe a lot of people don’t distinguish between investing and gambling. Sensible people don’t gamble with their retirement. The price of failure is too damned high.

I understand what you are saying here, but I think the issue is that when mentioning loosing 100% of $1,000 bet on roulette it seems to suggest that the risk of individual stock picking is losing 100% on the investment, when in reality that isn't the biggest "risk". Rather the bigger issue is that there is a much better chance of having a better return using a broad based index/total market index than individual stock picking. So the risk is leaving that money on the table which could affect the quality of life once one is past paycheck age.

That is what the OP seems to be missing in his statements or investment theory. It is like betting a dollar to win a dollar by picking a number 1-10. That is a bad bet But betting a dollar to win 11 dollars is fair and betting a dollar to win 15 is a good choice. The problem is it is harder to quantify that when picking businesses as opposed to numbers.

[BogleFan510]

A portfolio of individual stocks held long term is not such a bad investment choice. A worse expected return than modern low fee funds, all things being equal, but not horrible. Forty yrs ago when I started, it may even have been a better pick than most funds, as 1%+ fees were common.

Advantages are:
* Ultra low fee (in the past index fund fees with in the fractions of a percent did not exist.
* No churn, ultra low churn costs
* Some potential for exceptional returns

Disavantages are:
* Higher varience
* Tempation to fiddle with mix can reduce performance, create churn costs
* Few people actually take the time to learn how to pick good companies, follow them and then patiently construct a balanced mix of stocks, without help or 'suspect' outside research

People love to criticize 'individual active picking' but in reality, assuming picks are random an individual will beat active funds by a percentage equal to the fees they charge, so you likely outperform most active funds, compounding every year. Thats a lot of headwind.

My grandmother beat the market with an investing club and I still hold some of the stocks she picked, including Microsoft, Merck, Bank of America, ATT, Biogen. She pretty much invested her social security checks until she passed at 98, and I have a nice account I inherited and leave alone.

When I went to business school I participated in some psychological studies for fun (an small pay) that focused on valuation of assets. We were each given information about probability of value, given money, then participated in an auction for the assets with our `income'. I soon realized that because people are competitive, that the 'game' was optimized by actually not buying or bidding or trading anything. People wanted to win, so the auction always ended over the expected value. It was really boring to sit and not bid, but I did that and collected my food money. It was fun to see people react when their lottery tickets were cashed in for one of the possible values.

So for me the key is mostly behavioral. While a personal stock picked portfolio can and often does do great (I have several family members who own only individual stocks), one needs to have good behavioral traits to do well (the successful family members almost never sell). Many find it hard to buy more than 10 things and hold them for decades, reinvesting dividends, without fiddling.

That said, the rhetoric that it will end in disaster is overblown, as are the examples where one achieves 30% gains year after year. Usually an unpredicted, sudden big gain or two every decade, when the world realizes a company is great, so as I mentioned Indexes are a safer path for most.

[beernutz]

Just because things have been done for so long around here doesn't mean they can't change. I recall someone posted that in the beginning of this forum a 50/50 allocation was the norm. Look where we are now. I might be the next generation of the board's evolution.

And there we have it. Why do you want to change bogleheads which has a very clear investment philosophy outlined in the wiki that is largely the opposite of what you're proposing and defending?

[BogleFan510]

Just because things have been done for so long around here doesn't mean they can't change. I recall someone posted that in the beginning of this forum a 50/50 allocation was the norm. Look where we are now. I might be the next generation of the board's evolution.

And there we have it. Why do you want to change bogleheads which has a very clear investment philosophy outlined in the wiki that is largely the opposite of what you're proposing and defending?

+1 Bogleheads style is efficient, proven with data, and IMHO the best model to prevent the most common behavioral errors that often erode wealth. Solo stock pickers rarely have a clean plan, research, tools and support group that can help keep them anchored to their strategy. If you do want to pick stocks, an investment club with a wrtten plan, agreed criteria, long term focus, and where you share research and discuss companies is a excellent idea.

[tibbitts]

Just because things have been done for so long around here doesn't mean they can't change. I recall someone posted that in the beginning of this forum a 50/50 allocation was the norm. Look where we are now. I might be the next generation of the board's evolution.

And there we have it. Why do you want to change bogleheads which has a very clear investment philosophy outlined in the wiki that is largely the opposite of what you're proposing and defending?

+1 Bogleheads style is efficient, proven with data, and IMHO the best model to prevent the most common behavioral errors that often erode wealth. Solo stock pickers rarely have a clean plan, research, tools and support group that can help keep them anchored to their strategy. If you do want to pick stocks, an investment club with a wrtten plan, agreed criteria, long term focus, and where you share research and discuss companies is a excellent idea.

In fairness Bogleheads on the whole have not stayed anchored to every aspect of strategy - for example as the OP mentions, allocations have evolved over the years, and lately we see a lot of Bogleheads abandoning their SCV and international holdings. The low cost approach seems to be the one that almost all Bogleheads have stuck with best over time.

[langlands]

A portfolio of individual stocks held long term is not such a bad investment choice. A worse expected return than modern low fee funds, all things being equal, but not horrible. Forty yrs ago when I started, it may even have been a better pick than most funds, as 1%+ fees were common.

Advantages are:
* Ultra low fee (in the past index fund fees with in the fractions of a percent did not exist.
* No churn, ultra low churn costs
* Some potential for exceptional returns

Disavantages are:
* Higher varience
* Tempation to fiddle with mix can reduce performance, create churn costs
* Few people actually take the time to learn how to pick good companies, follow them and then patiently construct a balanced mix of stocks, without help or 'suspect' outside research

People love to criticize 'individual active picking' but in reality, assuming picks are random an individual will beat active funds by a percentage equal to the fees they charge, so you likely outperform most active funds, compounding every year. Thats a lot of headwind.

My grandmother beat the market with an investing club and I still hold some of the stocks she picked, including Microsoft, Merck, Bank of America, ATT, Biogen. She pretty much invested her social security checks until she passed at 98, and I have a nice account I inherited and leave alone.

When I went to business school I participated in some psychological studies for fun (an small pay) that focused on valuation of assets. We were each given information about probability of value, given money, then participated in an auction for the assets with our `income'. I soon realized that because people are competitive, that the 'game' was optimized by actually not buying or bidding or trading anything. People wanted to win, so the auction always ended over the expected value. It was really boring to sit and not bid, but I did that and collected my food money. It was fun to see people react when their lottery tickets were cashed in for one of the possible values.

So for me the key is mostly behavioral. While a personal stock picked portfolio can and often does do great (I have several family members who own only individual stocks), one needs to have good behavioral traits to do well (the successful family members almost never sell). Many find it hard to buy more than 10 things and hold them for decades, reinvesting dividends, without fiddling.

That said, the rhetoric that it will end in disaster is overblown, as are the examples where one achieves 30% gains year after year. Usually an unpredicted, sudden big gain or two every decade, when the world realizes a company is great, so as I mentioned Indexes are a safer path for most.

Great post. Something I've noticed is that the people who are drawn to and talented at individual stock picking tend to be exactly the type of people who are not particularly interested or versed in optimal portfolio allocation or academic finance. It is incredible to me to hear very successful investors like Warren Buffett or Howard Marks say things that a first year Econ PhD student could easily refute. Things like "diversification is a protection against ignorance" in the case of Buffett or that one should always keep a substantial amount of cash or "dry powder" to deploy when the time is right in the case of Marks. Ultimately, they are both successful because they know how to pick good companies and have an intuitive sense for good portfolio management despite their clear lack of technical knowledge and expertise in the area.

Conversely, people who are very versed in financial theory and portfolio allocation tend to have a purely quantitative or factor investing approach. They treat companies as a black box of financial ratios, calculate expected returns and volatilities, and run everything through an optimizer that spits out the appropriate weight allocations. Rarely would such a mindset be drawn to the qualitative thinking that is required to find good individual investments.

Because of this mismatch in skills/inclination, I think that those who are versed in portfolio allocation theory and are interested in picking individual stocks have a much better chance than commonly believed. The key as BogleFan510 says is to hold for the long term and think of your investments as companies, not stocks. Also, those stock pickers who don't have any background in academic finance would benefit massively from spending some time acquiring this knowledge.

[willthrill81]

Just because things have been done for so long around here doesn't mean they can't change. I recall someone posted that in the beginning of this forum a 50/50 allocation was the norm. Look where we are now. I might be the next generation of the board's evolution.

And there we have it. Why do you want to change bogleheads which has a very clear investment philosophy outlined in the wiki that is largely the opposite of what you're proposing and defending?

+1 Bogleheads style is efficient, proven with data, and IMHO the best model to prevent the most common behavioral errors that often erode wealth. Solo stock pickers rarely have a clean plan, research, tools and support group that can help keep them anchored to their strategy. If you do want to pick stocks, an investment club with a wrtten plan, agreed criteria, long term focus, and where you share research and discuss companies is a excellent idea.

In fairness Bogleheads on the whole have not stayed anchored to every aspect of strategy - for example as the OP mentions, allocations have evolved over the years, and lately we see a lot of Bogleheads abandoning their SCV and international holdings. The low cost approach seems to be the one that almost all Bogleheads have stuck with best over time.

Have there really been that many people who have publicly declared that they have given up on SCV and sold it? I only recall hearing a few do so. Many have pointed out that SCV has underperformed for quite a while, but many of them never appeared to hold it.

[tibbitts]

Just because things have been done for so long around here doesn't mean they can't change. I recall someone posted that in the beginning of this forum a 50/50 allocation was the norm. Look where we are now. I might be the next generation of the board's evolution.

And there we have it. Why do you want to change bogleheads which has a very clear investment philosophy outlined in the wiki that is largely the opposite of what you're proposing and defending?

+1 Bogleheads style is efficient, proven with data, and IMHO the best model to prevent the most common behavioral errors that often erode wealth. Solo stock pickers rarely have a clean plan, research, tools and support group that can help keep them anchored to their strategy. If you do want to pick stocks, an investment club with a wrtten plan, agreed criteria, long term focus, and where you share research and discuss companies is a excellent idea.

In fairness Bogleheads on the whole have not stayed anchored to every aspect of strategy - for example as the OP mentions, allocations have evolved over the years, and lately we see a lot of Bogleheads abandoning their SCV and international holdings. The low cost approach seems to be the one that almost all Bogleheads have stuck with best over time.

Have there really been that many people who have publicly declared that they have given up on SCV and sold it? I only recall hearing a few do so. Many have pointed out that SCV has underperformed for quite a while, but many of them never appeared to hold it.

I don't think there's any way to know for sure. You can add commodities to that list, although I think most people threw in the towel on those a while ago.

[TheoLeo]

"In Common Sense on Mutual Funds, [1] Jack Bogle suggests that a reasonable alternative to an index fund for some investors would be to hold a well-diversified portfolio of individual stocks, as long as they are held long-term, with a minimum of trading costs incurred." From the BH-wiki.

So as long as your choice of stocks is diversified and you buy and hold, your strategy falls into the realm of "reasonable".

If, however, you chose to concentrate your bets for outsized gains, then my question would be: how confident are you that you have a better crystal ball than all the other market participants? And if you are very confident, why?

[willthrill81]

"In Common Sense on Mutual Funds, [1] Jack Bogle suggests that a reasonable alternative to an index fund for some investors would be to hold a well-diversified portfolio of individual stocks, as long as they are held long-term, with a minimum of trading costs incurred." From the BH-wiki.

The problem with that approach is that the today's winners are often tomorrow's losers and vice versa. Sears was a great buy-and-hold stock until it wasn't. Same goes for many others. I understand the motivation to not day trade individual stocks, but I'm not convinced that buying a stock and purposefully never selling it is wise either. If you're going to pick stocks, then pick stocks.

[langlands]

"In Common Sense on Mutual Funds, [1] Jack Bogle suggests that a reasonable alternative to an index fund for some investors would be to hold a well-diversified portfolio of individual stocks, as long as they are held long-term, with a minimum of trading costs incurred." From the BH-wiki.

The problem with that approach is that the today's winners are often tomorrow's losers and vice versa. Sears was a great buy-and-hold stock until it wasn't. Same goes for many others. I understand the motivation to not day trade individual stocks, but I'm not convinced that buying a stock and purposefully never selling it is wise either. If you're going to pick stocks, then pick stocks.

One big reason not to go in and out of different stocks too much is the capital gains tax, which can be a huge drag on returns. For instance, assume your stock doubles after 10 years and you sell, incurring 15% capital gains tax. Amortized over the 10 years, you effectively paid a 0.7% drag on returns per year. If you're doing this in a retirement account of, of course this doesn't matter.

Besides the tax issues though, I'm highly doubtful that individual retail investors have much of an edge on the 1 year time scale. That is well within the time horizon of stock-picking hedge funds who are likely much more knowledgeable and have much more time and resources to read financial statements. IMO, success is much more likely to arise from bets on the 3-5 year or even 10 year time horizon. I agree that if your long term vision and thesis for outperformance of the company has changed, you should sell.

[willthrill81]

"In Common Sense on Mutual Funds, [1] Jack Bogle suggests that a reasonable alternative to an index fund for some investors would be to hold a well-diversified portfolio of individual stocks, as long as they are held long-term, with a minimum of trading costs incurred." From the BH-wiki.

The problem with that approach is that the today's winners are often tomorrow's losers and vice versa. Sears was a great buy-and-hold stock until it wasn't. Same goes for many others. I understand the motivation to not day trade individual stocks, but I'm not convinced that buying a stock and purposefully never selling it is wise either. If you're going to pick stocks, then pick stocks.

One big reason not to go in and out of different stocks too much is the capital gains tax, which can be a huge drag on returns. For instance, assume your stock doubles after 10 years and you sell, incurring 15% capital gains tax. Amortized over the 10 years, you effectively paid a 0.7% drag on returns per year. If you're doing this in a retirement account of, of course this doesn't matter.

Besides the tax issues though, I'm highly doubtful that individual retail investors have much of an edge on the 1 year time scale. That is well within the time horizon of stock-picking hedge funds who are likely much more knowledgeable and have much more time and resources to read financial statements. IMO, success is much more likely to arise from bets on the 3-5 year or even 10 year time horizon. I agree if that your long term vision and thesis for outperformance of the company has changed, you should sell.

I agree that tax drag is a potentially big deal when trading stocks in a taxable brokerage account. Of course, if you're in the 0% long-term capital gains bracket like more than half the households in the nation are, then it doesn't matter. And yes, trading individual stocks is best done in a tax-advantaged account like an IRA.

[dml130]

Something I've noticed is that the people who are drawn to and talented at individual stock picking tend to be exactly the type of people who are not particularly interested or versed in optimal portfolio allocation or academic finance. It is incredible to me to hear very successful investors like Warren Buffett or Howard Marks say things that a first year Econ PhD student could easily refute. Things like "diversification is a protection against ignorance" in the case of Buffett or that one should always keep a substantial amount of cash or "dry powder" to deploy when the time is right in the case of Marks. Ultimately, they are both successful because they know how to pick good companies and have an intuitive sense for good portfolio management despite their clear lack of technical knowledge and expertise in the area.

Conversely, people who are very versed in financial theory and portfolio allocation tend to have a purely quantitative or factor investing approach. They treat companies as a black box of financial ratios, calculate expected returns and volatilities, and run everything through an optimizer that spits out the appropriate weight allocations. Rarely would such a mindset be drawn to the qualitative thinking that is required to find good individual investments.

Because of this mismatch in skills/inclination, I think that those who are versed in portfolio allocation theory and are interested in picking individual stocks have a much better chance than commonly believed. The key as BogleFan510 says is to hold for the long term and think of your investments as companies, not stocks. Also, those stock pickers who don't have any background in academic finance would benefit massively from spending some time acquiring this knowledge.

Maybe that dichotomy of those two types of successful investors exists in the finance world, but I'm not convinced it's much of a thing for non-professional investors. Specifically, the first type (stock pickers like Warren Buffett or Howard Marks) is extremely difficult to successfully replicate (in terms of consistent long term market beating returns) for casual investors due to lack of necessary resources and time. If the full time mutual fund managers struggle to do it, it seems even less likely that a person picking stocks as a hobby will.

[GoldenGoose]

Whoa, there are too many posts since the last time I posted that it is not possible for me to address all the comments. Over the weekend, I have spent a lot of time thinking about what was said and the more I thought about them, the more curious I got. I have a lot of questions to ask but for a moment, let's forget about my theory. Let me ask the community this question. If I want to keep up with the standard "bench-mark" return of index investing, where should I park my money?

[GoldenGoose]

BTW I changed the title to "Active Index Investing vs Passive Index Investing" to closely reflect what I proposed.

[willthrill81]

If I want to keep up with the standard "bench-mark" return of index investing, where should I park my money?

Since you've been referring to stocks so far, I'm assuming that's the asset class you're referring to.

There are two main possibilities: the U.S. total stock market and the global total stock market. Some argue for one, and others argue for the other. My guess is that if you're stock picking, it's mainly going to be U.S. stocks, so the former probably makes more sense as a benchmark.

[dziuniek]

One can work longer - if that's possible - not a given.
Learn to live on less.
Save more.

If you have a record of beating the index consistently, why not? That's the problem - there is very few that do.
There's even less that can do it over a 20 year time frame. Probably 10 or less.

I would be more in favor of leveraging your holdings and sticking to an index. And NOT by a lot either. That's also risky as heck.

[GoldenGoose]

If I want to keep up with the standard "bench-mark" return of index investing, where should I park my money?

Since you've been referring to stocks so far, I'm assuming that's the asset class you're referring to.

There are two main possibilities: the U.S. total stock market and the global total stock market. Some argue for one, and others argue for the other. My guess is that if you're stock picking, it's mainly going to be U.S. stocks, so the former probably makes more sense as a benchmark.

No I am open to whichever one that gives the one single standard "golden return" that index investing proponents use to point out as comparing to active funds managers. Is it the SP500?