Occam and Passive Investing

Occam and Passive Investing

Occam’s Razor states: “when confronted with multiple problems to a solution, choose the simplest one.”

I like to believe that if William of Occam were an investor, he would be a passive investor rather than an active investor. Let me explain.


Elegance in Simplicity

Simplicity will be a reoccurring theme in my writings. I stated in a previous post that the most important investment advice is that investing should be simple. I truly believe that intelligent, prudent, and wise investing is always simple and easy to comprehend.

Investors break into two main groups: active and passive.

Active investors, as you would guess, are active in the stock market and with their portfolios. Active investors are by nature speculators. Speculators take on high risk for potentially high rewards. High risk because they are trying to forecast the future. High rewards because you cannot expect high rewards without equally high risk.

There is nothing fundamentally wrong with being an active investor. Many people make lots of money actively trading in the stock markets. Look at Wall Street. By no means am I saying you cannot make money by being an active investor. But the dangers of active investing lies in 3 major problems for the average investor:

1) Crystal Balls

This is nothing new. No one can predict the future with any level of certainty. No one. Ever read the fine print on any financial product? Under all the small print, it will say somewhere: “Past performance is no guarantee of future results.” They can’t predict the future. You can’t predict the future. It is very, very risky to try to predict the future in the stock markets. Really try to avoid doing it. Nassim Taleb’s “The Black Swan” is a great read for those of you who think it is possible to predict the future in the financial markets.

2) Zero Sum

When you are speculating on stocks, for every winner, there has to be a loser. When you win big on a speculative investment, someone has also lost money. When you lose big on a speculative investment, someone has gained money. And don’t even start to think that your homework on security analysis is giving you some market advantage. Do you really think that the minuscule research you have done even compares to the research the professionals have done on Wall Street? You are playing a game so handicapped it would be like trying to play chess against a supercomputer.

3) Financial Middlemen

To play the game, there are costs. Costs go both ways. Passive investors have to pay fees. Active investors have to pay fees. Two examples would be Management Expense Ratios (MERs) for passive investors and trading fees for active investors.

Let’s look at a breakdown of fees for the passive investor. I’m invested in TD E-Series Index Funds because they are the best Canadian index fund option for investors starting out. Under a balanced portfolio of Canadian funds, US funds, International funds, and Bond funds, the average MER charged is 0.42%.

Here is a look at the cost of a 0.42% MER over 1, 5, 10, 25, and 50 years in a portfolio:

Occam and Passive Investing

The chart above demonstrates the total kept and total lost of the entire investment portfolio. The amazing thing about the math formula is that you don’t even need to know the annual returns to calculate what sort of erosion MERs will have on a portfolio.

For an easier example, say you have a 2% MER mutual fund. All you need to do to figure out what the erosion of that 2% year in and year out is to take 0.98 and raise it to the power of whatever number of years you are looking for (0.98 because 100 percent minus 2 percent (MER) equals 98 percent). Say you want to know what 2% MER will have after 30 years. Either plug in 0.98 to the power of 30 in your calculator or manually multiple 0.98×0.98×0.98×0.98×0.98…. 30 times of that is 54.5%.

This means that after 30 years of investing your money at 2% MER, you are left with only 54.5% of the total investment while the bank has taken 45.5% of your money in fees. It is very shocking.

Using another example, let’s use a static dollar amount invested over the same time periods at the same MER rate and see what happens to the money as it compounds over time. The graph below is what I’ve recreated using Vanguard’s calculator on the effect of MERs. We will assume a statics $10,000 investment with a 6% annual return with a 0.42% MER:

Occam and Passive Investing

This chart is slightly different from the first one. This demonstrates the returns generated and shows returns lost and returns kept. The previous chart showed total investment kept and lost.

Now, for comparison sakes, let’s look at the effect of a hypothetical actively traded account with the same conditions as above. We will assume a static $10,000 investment with a 6% annual return. We will also assume 1 trade a month at $29 a trade (the amount charged by TD for trades of this dollar amount):

Occam and Passive Investing

I realize that the chart and graph above is slightly off as I did not adjust the trading fees for when the investment surpassed $50,000 as TD charges a lower trading fee when you hold assets over $50,000. However, I feel that the graph shows what I wanted to demonstrate, which is that trading fees produce a large drag on investments. As an active investor, you need to be aware of the impact of the trading fees you are paying.

For example, if you buy a stock and pay $29 for the trade, your investment has started at a negative yield. Your stock needs to yield $29 before you break even and start beginning to make a positive return. When you are starting out as an investor, trading fees can be an immense hidden cost that you might never have taken into account.

Pros and Cons of the Examples

Now, I understand these are very controlled scenarios and there are several things about them that are very far from investing in real life.

First, you probably wouldn’t just put $10,000 and never add any additional amounts into your savings.

Second, you probably wouldn’t make just one trade a month actively trading in the stock markets.

Third, there are too many variables for each unique investing circumstance.

However, I believe these are useful examples as they can demonstrate the effect fees can have on investments in a very general sense. It provides a general idea on the effect of drag that fees create on your investment portfolio. And it teaches you to be aware of these investments drags. In both active and passive investing situations.

Occam as a Passive Investor

Fees need to be paid regardless of what style of investing you choose. There will be performance drag no matter what style of investing you choose. You can’t play the game for free. However, you can control the amount in fees you pay.

As a passive index investor you invest your money in a very elegantly simple idea. First, you are investing your money for the long haul rather than looking for a quick flip. Second, you are buying the entire market, bypassing any attempt at crystal ball gazing and predictions since you accept the average return of the whole market. Third and finally, you can control the cost drag on your investment by buying low-MER index funds rather than paying fees every time you make a trade.

Between active investing and passive investing, employing the principle of Occam’s Razor would clearly point you in the direction of passive investing through low-cost index funds.

I would love to hear your thoughts on active and passive investing. Try to convince me which style is better for the average investor: active or passive?

6 thoughts on “Occam and Passive Investing

  1. I’m passive all the way (heck I even wrote a book called “The Passive Income Investor”!) People really underestimate how difficult it is to beat the S&P 500 year-in & year-out by even 1 percent without taking additional risk and huge amounts of time & effort.

    1. Enjoyed your article and the thought processes that went into it. I agree that passive investing can often perform as well or better than active investing. I do a bit of both because I enjoy the stock markets and learning opportunity. For those that don’t, its wise to stick with a passive (and diversified) strategy.

      1. I wouldn’t rule out a tiny “active” investing component for myself either. The majority of my assets would be in index funds and I’d have a little fun money to play with stocks here and there. I think for most people, if they aren’t ready to do their homework, they should go completely with low cost index funds. If they feel the need to actively trade, it should not be a significant portion of their investment portfolio because actively trading is highly risky and I don’t think the nest egg should be used to bet on the markets 🙂

    2. I agree! A future post will be on the stats of actively managed funds vs. a passive index fund comparing the annual returns. The stats on funds being able to beat the index is shockingly underwhelming, especially after you subtract high MERs.

  2. Great post. You’ll probably find what many of us (who have been at the money game for a very long time) discover with actively managed vs. passively managed. There’s no advantage / edge in actively managed.

    For those in a position to do so, one of the best investments is in yourself. Whether it’s learning new skills, paying off debt or investing in your own business, at least there’s a little more control over the outcomes that get produced.

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