Does Passive Investing Still Work in Post-Pandemic America’s “New Normal”?
The world has changed. Most people have accepted that we are living in a “new normal” that is very different from what we once knew. Economically, we’re still struggling to get back on track. Psychologically, our mindset is more cautious and defensive. The 2020 pandemic, much like the events of 9/11 twenty years earlier, permanently altered our reality.
Unfortunately, the financial sector hasn’t caught up yet. Many advisors are still using pre-pandemic passive investment models. They point to historical market trends as “evidence” that their clients’ portfolio losses will somehow turn into gains over time. That’s what happened in the last century, so why not now? In this article, we’ll answer that question.
Innovation has changed the stock market
Several significant events in the 21st century have changed the way the stock market works. The first is the evolution of social media. Just last year, we saw a group of traders on Reddit drive the price of GameStop up 600%. That wasn’t possible in the 20th century, and it’s just one example of how social media can influence market movements.
Another innovation in stock trading is the rise of retail investment platforms like Robinhood. Investors there don’t have the same kind of capital that institutional investors work with, but their activity influences stock prices. The retail trading factor is not transitory, despite what declining numbers seem to indicate this year. Retail investors are here to stay.
The third factor to look at is algorithmic trading. According to Wall Street trading data, 60-73% of US equity trading is done with investment algorithms. Trades happen automatically based on mathematical equations that are designed to minimize losses. Unfortunately, those trades can also cause large and often unpredictable price swings, making the market more volatile.
What does all this have to do with passive investing?
Let’s go back to the concept of passive investing for a moment. The premise is that “buying and holding” a mix of stocks, bonds, and ETFs will produce long-term gains for your portfolio. During the 20th century, the S&P 500 averaged a return of 10.34% a year. That’s the number that most advisors use when presenting a passive investment strategy.
It’s not accurate. From 2001 to 2022, the average market return for the S&P 500 dropped to 7.02%. If we adjust for inflation, that number comes down to 4.48%. We’re a full generation into the 21st century, and the projected returns for passive investing models based on the S&P 500 have already been cut in half. That’s our “evidence” that it doesn’t work.
What’s interesting about these numbers is that the market experienced a historic bull market from 2009 till January 2022. It was fueled by tech stocks. While the S&P 500 was declining, the Nasdaq index produced an annualized return of 13.9% from 2011 to 2020. That’s important. We’ll explain why in the next section.
Why passive investing isn’t working
Are you still with us? This is where we bring it all together. Most passive investing models are constructed using a set of guidelines called “modern portfolio theory.” You may not have heard the term, but you’re likely familiar with the concept. It advocates for an investment portfolio that is balanced amongst eleven recognized market sectors. They are:
4. Consumer discretionary
5. Consumer staples
6. Health care
8. Information technology
9. Communication services
11. Real estate
The reasoning for this seems sound at first glance. Diversify your holdings across all market sectors, and losses in one should be offset by gains in another. It’s essentially a check and balance system to mitigate losses. That worked well twenty years ago. They didn’t have a post-pandemic mindset, social media, retail investors, or algorithmic trading back then. In addition, bond rates, which acted to offset losses from the equity portion of the portfolio, were much higher than they are today. That hedge no longer exists.
Technological innovations and overinflated valuations of tech companies have changed the landscape. Passive investment models don’t account for that. They rebalance based on the designed model that doesn’t necessarily weigh certain sectors higher than others. Gains in information technology don’t benefit a portfolio if there are losses in all other sectors.
One of the major problems with passive investing is that you are diversified across multiple asset classes to minimize market risk, which only seems to work in an up market. In other words, when the market is going up, there is a difference in returns between risk classes, with the least risky assets going up less than the riskier ones. It is not uncommon to see a difference of more than 300 basis points from the least risky to the most risky investment returns.
When the markets start to correct and go down, the differences compress to as little as 15 basis points, as occurred in the 2008 financial crisis. Another way of looking at this is that diversification seems to be a drag on earnings when the markets are going up and doesn’t provide the needed protection when the markets are going down.
The case for active investing
That’s enough about the problem. Let’s talk about the solution. Active investing, or “Tactive Investing,” as we like to call it, is an investment strategy that advocates active trading when market conditions change. If financials are booming and industrials are in freefall, we dump the dogs and focus on what’s making money right now. Sectors don’t matter. It’s about returns.
Proponents of passive investing will tell you that active investing is risky. Their S&P 500 model is down 13.73% YTD in 2022. Tactive investing strategies take advantage of market conditions and analyses that seek to minimize drawdown. When Coinbase went public in 2021, Bitcoin hit an all-time high of $64,800. Their model doesn’t even have a crypto category.
True diversity in an investment portfolio is more than just moving money around between sectors. Tactive advisors use crypto, insurance, alternatives, and even liquidate to cash when the conditions call for it. Our philosophy is that long-term wealth is built by avoiding significant drawdown. The “new normal” is too unpredictable to use old-school passive models.
Tactive Investing is the “New Way” for the “New Normal”
Modern portfolio theory is no longer modern. It’s outdated. The market moves too quickly for a passive investing model constructed around market sectors to be effective. Tactive is the “New Way” to invest in the “new normal.” Visit TactiveWealth.com to learn more and get started today.
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