Passive investing part 3: crowding, forecasting and (lack of) emotions

The third post of my series of articles focused on passive investing for Europe based investors, I will continue on the topic of why passive investing can be positive for your investment performance even before lower fees are taken into account.

Passive approach allows you to avoid hypes and fads

Maybe one of the most important things in passive investing is to stick with your pre-defined policy. This helps you avoid the following issues:

  1. crowding
  2. forecasting
  3. emotions driven decision making

Crowding

Active managers tend to be optimistic and pessimistic on the same firms at the same time and portfolios that buy stocks on which active managers are the most negative and sell stocks on which they are the most positive tends to perform very well. The mechanism is clear – the whole investing world reads the same news and this leads to, on average, similar conclusions. This leads to two issues: if prices of stocks all managers buy go up and if prices of stocks all managers hate (or sell) go down, the disliked companies eventually get pushed to a price advantage that more than compensates for the perceived lack of performance of their underlying businesses. Second reason has to do with forecasting.

Forecasting

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

Warren Buffet

Forecasting is extremely hard. Although forecasts can help understand what the outlook is “right now”, it rarely is the case the situation stays the same and there are just too many unexpected events that can make a 12-month forecast useless in a day. Central banks have gotten infamous with their ever revised predictions of lower inflation for longer in recent years. But especially during Donald Trump’s presidency with steps taken on international trade which are near impossible to anticipate, it is fairly clear that any forecast needs to be taken with a grain of salt.

There are, however, trends worth being aware of such as demography, major shifts in the economy (e.g. fossil fuels) and shift in the relative importance of certain regions (e.g. Asia rising and Europe relatively fading) but even then this is largely not important for well chosen diversified passive investment policy.

Emotions driven decision making

Lastly, often investor’s worst enemy is the investor herself. Emotional decisions lead to bad actions taken at the worst time possible. A few examples:

  • selling due to market collapse
  • not buying according to the investment policy because market just crashed, buying when market bounces back
  • buying after strong returns due to “fear of missing out”
  • trading too often, increasing fees in the process
  • focusing on opportunities with short term payoff while not pursuing better long term opportunities

To relate the above to the first two points of this article: when active managers are the most fearful and forecasts are the most negative, it is probably the most likely that the future won’t be as bad as expected and asset prices will recover. If you stick to your passive investment policy, you can avoid even having to take any decisions, saving your time but also harvesting returns that other leave on the table.

As always, please share any remarks or questions in the comments below or feel free to use the contact page on this website.

Published by everydayinvesting

Amsterdam based. There will definitely be a bias towards topics relevant to my work. I'm interested in investing, markets, economics, politics, history but also machine learning, statistics and how (whether) all these can be combined. I have questions and let me know if you have answers! Always happy to discuss any of the below and more. - can machine learning be applied to investing? - what's the future of active investment management? - what's the future of passive investment management? - where's the best trade now?

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