SmartMoney Rules™ on Active and Passive Investing… and why it matters to you!

by Steve Juetten, CFP® and Dan Maul

April 2016

Helping you take care of your money so you can do more of what you love! SmartMoney Rules™ on Active and Passive Investing … and why it matters to you!

By Steve Juetten, CFP® and Dan Maul

March 2016

Introduction

You may have heard the terms "active" and "passive" investing. In this special report, we are going to shed some light on these two terms and explain why it matters to you.

First, we want to make a distinction between investing and saving. Investing is long-term oriented and the objective is to make your principal grow as much as possible. Saving is short-term oriented and the objective is to protect your principal and make it grow a little. Unfortunately, there is no such thing as a free lunch. If an investor wants his or her principal to grow significantly, she or he must accept more risk as defined by the potential loss of the principal. Savers are willing to have less growth in order to have more protection of the principal. Before we get into the differences between active and passive investing, here is a brief background on investing.

Investing Basics

Most investors assemble a mixture of stocks, bonds, and cash with their goal being to see their investments grow. While some people buy individual shares of stocks, most investors use mutual funds to create a mix of securities. A mutual fund takes in money from many smaller investors and then buys stocks, bonds or other securities with the money that investors have contributed.

Assembling a mix of securities (or mutual funds that hold securities) is called a portfolio and many academic studies show that the primary driver of an investment portfolio's return is its asset allocation. Asset allocation refers to how the investor splits or allocates her or his money between major classes of investments: stocks, bonds, and cash. Academic studies have shown that asset allocation is the most important factor in the return of a portfolio. Still, most investors waste their time trying to decide between the individual securities that are within asset classes.

What is active and passive investing?

Active investing refers to the approach an investor (or mutual fund manager on behalf of the fund’s investors) takes when he or she is picking individual stocks, mutual funds, or other securities that they believe have the greatest potential to appreciate. When a security the investor has chosen does not meet expectations, it is sold and another one is purchased in its place. This is what we mean by active investing.

Passive investing is the approach an investor uses who is simply trying to match the returns of an asset class as a whole. A passive investor will choose an entire asset class (or a subset of an asset class) instead of trying to pick an individual stock or mutual fund. Sometimes you will hear passive investing referred to as "index" investing. However this is not quite accurate; index investing is the most common approach to passive investing, but there are others. Index investing is used when an investor chooses a mutual fund that matches the securities held by an index. The most popular index is the Dow Jones Industrial Index, made up of the 30 largest companies in the United States. There are many other indexes, for example, the S&P 500 Index (largest 500 companies in the U.S.), Russell 2000 (U.S. companies ranked #501 to 2,500 by size) and many others representing virtually every security market in the world.

Most investors don’t choose individual stocks or bonds. They use a mutual fund to choose securities for them. Mutual funds follow one of two approaches when they choose a security: either active or passive so when an investor chooses to invest in mutual fund “A” or “B”, the investor is choosing an active or passive approach. Approximately 75% of individual investors use an active approach to investing. Among major institutional investors, for example corporate and public pension plans, approximately 66% use active investing.

In summary, think of active versus passive investing this way: suppose you're sitting on a hill, looking out over a forest made up of different kinds of trees and you want the forest to grow. Active investors will try to pick which individual tree will grow fastest. Passive investors will choose the whole forest.

Which approach is better?

Independent, unbiased academic research shows that passive investing provides better returns than active investing over longer time periods. Standard and Poors Company keeps track of the results that active and passive mutual funds achieve. Since 2002, they have published the SPIVA (S&P Index Versus Active) Scorecard. Here is what they found:

Compared to an active approach to investing, indexing almost always works better over a five-year horizon.

Over shorter time periods like one or three years, one approach may be better than the other, but over five years or more, a passive approach is better. Look at this graph showing how various investment sectors fared against their indexes. % Active Funds That Failed to Beat Their Index (2010 - 2014)

100% 89% 90% 85% 87%

o t

80%

d 72% k e l r

i 66% a 70% a 63% F m

t h a c 60% h n t e

s B

50% d n m r u o F 40%

f r e e v i p t 30% t c u A

O f 20% o

% 10% 0% International Gov't Interm Emerging U.S. Mid Cap U.S. Small Cap U.S. Large Cap Bond Markets Stock Fund Category

Comments:

1. Passive investing works equally well among mutual funds that focus on large, mid cap and small cap companies. Many times you will hear a financial advisor who believes in active investing say something to the effect that large caps are an efficient market and should be indexed, but small caps are an inefficient market and should be actively managed. This chart refutes that claim. 2. By the way, municipal bond funds have a particularly tough time beating benchmarks. The data show that only about 9% of mutual bond funds have beaten their benchmark over a five-year period 3. In the interest of fairness, we want to point out that there are two categories that SPIVA measures in which active funds outperform their passive counterparts: funds that focus on small cap companies outside the U.S. and mutual funds that invest in the debt of emerging markets like Brazil, China, India and Russia. 4. Random probability predicts that 25% of mutual funds would be able to stay in the top quartile for five years. In fact, no asset class of actively managed mutual funds (not just the ones shown above, but including all asset classes that SPIVA tracks) has seen more than 20% of funds with top quartile performance for five years. In other words, you would have a better chance of picking an actively managed mutual fund that would remain in the top quartile of performance over five years by throwing a dart at a list of mutual funds. 5. One of the arguments that active mutual fund proponents use is that actively managed mutual fund managers have the opportunity to in and out of positions as market conditions dictate. The argument goes that this should provide a significant advantage for actively managed mutual funds. Unfortunately, this is not the case. In the two bear markets we have seen over the last decade, most active managers failed to beat their benchmarks. For example, less than 5% of actively managed small cap growth mutual funds and less than 10% of large cap growth mutual funds were able to beat their benchmark in 2008.

Source: U.S. SPIVA Scorecards; more information can be found at www.standardandpoors.com/indices/spiva/en/us.

Reasons Investors Still Use Active Investing

If passive investing is superior to active investing, why do people still invest actively? There are probably many reasons, but here are some we’ve observed:

Many people don’t know passive investing exists. Unless an investor has an MBA, he or she probably has never heard of the efficient market theory or capital market pricing (two key concepts in passive investing). If an investor has heard of passive investing, and asked her or his broker or financial advisor about it, the response probably went something like this: "Indexing is a good strategy, but it gives you average returns. Since we at the XYZ firm can give you above average returns, why would you settle for average returns?" In other words the people that could educate the average investor about passive investing, are the ones whose interests are not aligned with the investor and in fact, whose interests are opposite of the average investor when it comes to indexing. Brokers, fund managers and Wall Street professionals need to convince their clients and the investing public that only a skilled professional has the ability to achieve superior returns. If it were widely known that passive investing was a viable alternative, they would all lose their jobs.

Belief in the Performance Fairy. Frank Armstrong III in his book "The Informed Investor" coined the phrase "the performance fairy." Mr. Armstrong notes, “if you believe in performance fairies, you are convinced that somewhere out there is one that can beat the market. You might even believe that you yourself are a performance fairy. You persist in this delusion against all the available evidence, but remember, it is extraordinarily difficult to beat Mother Market. Few actually do it over the long haul, but many a fool continues to confuse pure, dumb luck with skill." This is a clever and cute way to point out that all around us, especially in Western society, we celebrate the winners and feel sympathy for losers. This is especially true among men. After all we celebrate the winners of sporting events, political elections and the person who brings home the biggest paycheck. So is it no wonder that many investors continue to look for the performance fairy.

There will always be actively managed funds with superior historical performance over a short period of time. But choosing investments based on past performance is like driving your car while looking in the rearview mirror. Picking funds that were top rated doesn’t work well either. Hindsight is 20/20. Once you learn that after expenses, only .06% of managers beat their benchmarks through skill¹, convincing yourself that you or any financial professional can consistently identify who they are becomes a disheartening task. That’s one reason “Past performance is not a guarantee of future results” is a caution the Securities and Exchange Commission requires to be included on every mutual fund prospectus.

1 Barras, Laurent, Scaillet, Wermers, and Russ, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”

We believe we are right most of the time. This idea comes from Katherine Schulz, author of the book "Being Wrong." In her book, the author notes that we believe we are basically right, basically all the time, about basically everything. We go through life with this assumption and gather evidence that confirms this assumption by somehow or another managing to get along just fine most of the time. We become so emotionally invested in our beliefs that we are unable or unwilling to recognize them as anything but the truth. That explains why being wrong can so easily wound our sense of self. It also explains why we hang on to long-held beliefs or ignore evidence that contradicts a long-held belief, even when it is compelling and why we resist change.

We hate to admit mistakes. The corollary to the common problem of believing that we are right most of the time is that we hate to admit when we are wrong. We tend to think that others and not us make mistakes because being wrong is just not how we see ourselves. No one likes to be told that they have been doing something wrong all their lives. And this is what we do when we tell someone that passive investing is better than active investing. And what do people do when confronted with information that shows him that they have been wrong? Most people, when directly confronted with proof that they are wrong, do not change their point of view or course of action, but justify it even more tenaciously.

We believe that activity means we are in control and activity is also a way to reduce uncertainty. At a deep level, we want to feel like we're in control of our lives. I'm sure from an anthropological standpoint, this helped us to survive in a world that threatened us at every turn. And we also don't like uncertainty. Because the future is unknowable, that is uncertain, there are times we feel out of control. After all, most of what happens to our investments seems like they are out of our control. Market bubbles and crashes, worldwide economic and political events, and interest rates, all have an effect on our investments and there is nothing we can do about them. As a result, to offset the lack of control and increase our feeling of certainty, many investors trade stocks, change investment advisors, buy and sell mutual funds, and change their 401(k) plan allocation. It reminds me of the Gary Larson cartoon in which two buzzards are sitting on the limb of a dead tree. One buzzard says to the other, "To heck with patience, let's kill something." Daniel Kahneman in his book "Slow thinking, Fast thinking" points out that active trading (aka fast thinking) is very detrimental to investing success. Instead, what we need is slow thinking, which is the essence of passive investing.

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.””

-- Blaise Pascal, French philosopher How to Implement a Passive Investment Approach

Creating a passive investment approach is surprisingly easy. The steps are these:

1. Educate yourself by reading one or more of these books:  Ditch the Guesswork: Creating Reliable ROI for Time-Starved Investors by Steve Juetten, CFP®  The Investment Answer by Dan Goldie,  The Coffeehouse Investor by Bill Schultheis,  The Informed Investor by Frank Armstrong III,  The Four Pillars of Investing by William Bernstein,  The Only Guide to a Winning Investment Strategy by Larry Swedroe,  Any book by John Bogle. 2. Create a target mix of stocks, bonds and cash that gives you the potential for returns balanced against potential losses that is right for you. This return/risk trade off is based on historical experience over a long period of time. 3. Choose index or other passive mutual funds within each asset category that give you sufficient diversification. The major categories are:  U.S. large, small and medium companies  Non-U.S. companies in developed and emerging markets  Commercial Real Estate  Commodities  Natural Resources  U.S. corporate and government bonds, including Treasury Inflation Protected Securities (TIPs).

If you want to do this on your own, consider mutual funds and Exchange Traded Funds or ETFs (an index fund that trades like a stock) from Vanguard or iShares. TD Ameritrade, a national discount broker, offers a large list of ETFs that trade for free.

If you want to work with an advisor, use DFA mutual funds. These funds have proven to be superior passive investments compared to most other passive mutual funds. Visit www.dfaus.com for more information on these unique investment vehicles.

4. Rebalance your portfolio to the original target for each mutual fund when they get out of balance with either too much or too little in a fund. 5. Be patient. If you’re growing things in the garden, you don’t run out every day, pull up the plants to check the roots, do you? It’s the same with passive investing. Patience leads to success. Stay the course and don’t be dismayed or persuaded to change your approach by the television media, your friends, co-workers or something you read in a magazine or on-line. Summary

Active investing is the process by which an investor attempt to “beat the market” by trading in and out of securities when they guess the value of the security is going to go up or down. History shows this is a fool’s game.

Passive investing is the process by which an investor accepts that she or he cannot guess the future and, instead, accepts market returns. History shows this approach provides above average returns.

While evidence shows that passive investing is superior to active investing, some investors persist in following the active approach to investing for one or several reasons:

 We are strongly influenced by brokerage firms, mutual funds and the media whose future success depends on investors actively trading. These sources continue to entice investors with the latest and greatest investing ideas. Before long, we feel stupid if we aren’t following the active investment ideas we read and hear about.  Many investors don’t know any better so they follow the lead of the groups mentioned in the previous bullet.  Some investors believe in a performance fairy and think “If I can just find the right mutual fund or financial advisor who knows ‘the secret,’ I’ll be a success.” Unfortunately, there is no such thing as a performance fairy.  Most human beings think they are right about most things and therefore conclude that they must be right about investing. The other side of this coin is …..  People hate to admit they are wrong and if they have been investing actively, it’s hard to switch approaches because it would mean they have to admit they were wrong.  It’s hard to do nothing, even when we know that’s the best thing to do. Sometimes investors equate passive investing with doing nothing and it’s hard to sit on your hands when you see your hard earned investments going up or down.

Highly functioning adults learn from their mistakes, while insane people keep doing the same thing and expect the outcome to be different. When it comes to investing, this is especially true. Passive investing always wins over active investing. You would have to be crazy to think and act any differently. About the Authors

Clients find that working with Steve Juetten, CFP® is a joy because he listens, cares, really knows about personal financial matters and holds their interests before his own. He is a fee-only financial advisor (meaning, unlike many financial advisors, he doesn’t sell any products or take any commissions) and has only ever been a fee-only advisor since he began serving individual clients over ten years ago. And clients must like what he does because he’s been named a Five Star Wealth Manager by Seattle Magazine for five years in a row. Less than 5% of financial advisors earn this distinction. Steve is often quoted in Forbes.com, Bankrate.com and MSN Money.com on a variety of personal financial planning topics.

You can reach Steve at 425-373-9393 or by email at [email protected]. His company web site address is www.finpath.com.

Before joining Juetten Personal Financial Planning as an Independent Advisor Representative in 2011, Dan Maul was a nationally recognized expert on retirement plans for companies and small business owners. His expertise was the subject of features in , Forbes, Money Magazine, Inc., CFO, Nation's Business, Kiplinger's Personal Finance Magazine, U. S. News & World Report, MSN.com and on the Business Radio Network.

In addition to fly fishing and gardening, Dan is an active volunteer and was recently named Volunteer of the Year by Olive Crest, a not-for-profit that provides services and families for abused children.

You can reach Dan at 425-827-0511 or by email at [email protected].