Passive stock investing is another market myth as a result of hindsight. In reality, timing of market entries and exits determines performance. Passive stock investing can make sense only in the context of a diversified portfolio in several asset classes.
Proponents of passive investing usually make up strawman arguments that center around the high cost of active trading and the inability of technical analysis to generate alpha. However, in recent years trading cost has plummeted and also not all technical analysis is useless. I agree with some of the arguments involving chart patterns and naive analysis but as it will be shown below, even a simple moving average crossover has outperformed passive index tracking in the last 20 years.
The correct premises are that a large part of technical analysis is bad and overtrading may lead to excessive friction and even failure but these two premises alone cannot support the conclusion that passive investing is superior to market timing based on sound technical analysis. In the last 20 years there have been two major market crashes during which the S&P 50o index lost in excess of 45% of its value. Post hoc one could argue that passive investment pays in the long-term but when an investor is losing 40% – 50% of her account the most probable decision is to liquidate and run for cover. Actually, funds issue liquidation notices when the drawdown is much less than that. Averaging down automatically converts a passive index strategy to an active one. When markets crash, passive investors are badly trapped. However, some simple technical analysis signals can prevent these disasters. The example below is based on comparing passive investing in SPY for periods of 10 and 20 years to the results from a simple 50-200 moving average crossover system that buys when the 50-day simple moving average crosses above the 200-day simple moving average and reverses when the opposite occurs. All the finding are summarized on the chart below:
Total buy and hold returns (with dividend reinvestment) for the 20-year and the 10-year passive tracking periods are shown at the top of the chart along with maximum drawdown and MAR (the ratio of CAR to max. drawdown). A long-only golden cross strategy outperformed the passive 20-year strategy by more than 150 basis points per year at a significantly higher MAR because of the much lower drawdown. Same results for the passive 10-year strategy which was outperformed by 130-155 basis points also with a significant rise in MAR.
It is evident that the short component of the active strategy reduces MAR but this is only due to the fact that the longer-term bias of SPY is up. In the case of a protracted bear market in the future such short component may prove beneficial assuming shares can be borrowed and sold short.
Conclusion: Passive investing, and in particular passive index tracking, is another market myth that serves the agenda of its creators. Actually, passive index tracking should be part of a sophisticated allocation scheme involving bonds and commodities but this is technically even more difficult and ambiguous than sound technical analysis that is free of wishful thinking.
Edit on 06/07/2014, 12:12 EST: Someone brought up the issue of taxes and how they lower the returns of active strategies. Regardless of the impact of taxes, there is nothing passive investors could do about the -55% drawdown in 2008 and this was the counterargument I brought up. Then I was told that had investors stayed in the market during the financial crisis they would have recovered. But this is exactly what hindsight is. Most of those who are proponents of passive investing do that after they look at a long-term chart. But future charts may not look similar to the past. Triggering a sell signal may make the difference between saving a fortune and eating cat food after retirement.
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Disclosure: no relevant positions.
Charting program: Amibroker