Passive Investing and Non-Linearity

August 2nd, 2016 by Potato

This is a recording of a rant I put together originally for the DIY investing course, but it didn’t quite fit the tone of the course. I didn’t want to throw it away, so here it is as a quasi-podcast for you.

Click here to download the MP3 of the rant.


Markets don’t have simple stories. Market indexes are very useful for simplifying down what’s happening for a quick news report, and with index funds it’s also a handy way to relate that back to your portfolio: if a market index is up, your holdings mirroring that index are also up. But just because we can boil it down to a monosyllabic summary of the action for the day or year or whatever (up/down/flat) doesn’t mean that it’s a simple lever someone out there is pushing, though we like to think of it that way.

We want to think of it that way. We’re comforted by the fairy tales of causation in the news: condition X happened, therefore event Y happened.

It tickles the part of your brain that wants to recognize patterns and fill in the next part. “Here’s a condition, what’s going to follow, onboard pattern engine?” But the damned thing of it is, sometimes there are causal connections, and often there aren’t. If it was just totally random noise we might be able to give in to it, but it’s not — there are some really plausible-sounding stories out there, explanations so great they can explain market moves in all directions.

The stock market is a complex system. It is made up of people (and computers pretending to be people) all acting for their own interests and reasons. Many are only looking at one or two particular companies versus trading a large index. Some are long-term investors unconcerned with day-to-day moves. Some don’t look at the news or events or anything external to the market, making decisions based solely on the trading activity they see other people doing.

I think it would be a really interesting project to one day survey everyone who made a trade and find out why they made the trade that you did. I suspect you would find almost none aligned with the headline in the news that day: “market falls on worries over capital controls in China” or whatever. Instead it would be a thousand different stories that vary from an automatic investment plan to what they had for breakfast to responding to commentary someone else made.

The market average is made up of hundreds of stocks being traded by millions of people around the world, each with their own lives and stories and perception filters, and even though it will all average out to a single, simple result (up/down/flat), it is not because of a single, simple cause.

It reminds me of that quote from Men In Black:
A person is smart. A kind, compassionate being. People are dumb, panicky, dangerous animals. [paraphrased]

One thing I try to explain over and over again when talking about index investing is how hard it is to out-smart the market consistently. The whole point is to try to shut out the non-actionable noise, to avoid forced errors, and stick with a consistent, easy strategy… then move on with your life. It is a very difficult thing to do, because you have to have some kind of faith in the markets, and you have to turn off your pattern-seeker. One of the worst things that can happen to a new investor is to make a decision based on some piece of trivial news, and then make money based on that. Because then it’s nearly impossible to turn off the competitive, out-thinking, out-guessing, pattern interpretation engine.

At a library talk I gave recently I had a number of questions from the audience that I didn’t do a very good job of shutting down: things like recent articles about negative interest rates and how that will affect a passive strategy, or what the cause of Black Monday was in 1987. But the fact that the questions were coming in the first place means I wasn’t doing a good job of explaining that passive, control-what-can-be-controlled philosophy.

To try to explain it again in a slightly different way, there are a few good reasons why the passive approach is a smart one, in other words, why active investing is hard.

1. Lifestyle: it requires effort and expertise to be an active investor.
2. Evidence: even the experts do not have good odds of out-performing when picking stocks.
3. Non-linear: the links between putative causes and investment returns can be very non-linear and non-obvious.

For #3, this is the point I think a lot of people are missing on why it’s just so difficult to be an active investor and out-perform. There’s the efficient market side of it: the market is made up of people with the same information you have, so a news article about something (negative rates or employment or whatever) is difficult to use to get an edge. How much of that were people already expecting, how much will affect future business activity, and how much of that will affect future stock/bond returns?

There’s also the complexities of the connection between the real world and the stock market at play. Monish Pabrai has a flashy slideshow about this, but it’s pretty easy to pull examples out of a hat from the past. There have been many inventions where it has been easy to say “this is going to change people’s lives” and be absolutely correct. Automobiles, airplanes, genetics, microchips, the internet, cell phones — these have all undoubtedly been wildly successful inventions that have changed the lives of billions of people.

And none of that knowledge has been good enough to help you make money as an investor. Even if you knew for sure — even if you traveled back in time with the absolute certainty that in a few decades’ time the sky would be filled with jetliners, the pockets of the passengers filled with devices laden with microchips, and the roads choked so full of cars that a decent marathon runner could jog from the suburbs to downtown faster than a car could take the highway — even then, you would be hard-pressed to make money from that knowledge. Most of the car companies in the early phases of that revolution went bust. Airlines go bust so often it’s a joke amongst investors. There’s been one big winner in the cell phone industry, and it’s one of the companies that started off selling computers.

The internet did indeed change our lives. But it also led to a big stock bubble and collapse, showing the importance of higher-level thinking. Indeed, many of the would-be investors and traders of the time were faced directly with the evidence of the internet’s impact, as they placed their trades online in the new discount brokerages that became available. They could not ignore the impact the internet was making or how fast it was growing. So many of them thought the same thing, and bought the same stocks, leading to the bubble, which blew up and cost many of them a lot of money. It’s not enough to know the first part of the story, but also look at what all the other investors (humans and computers) are doing — what’s priced into a stock, what’s a real opportunity, what’s a bubble brewing?

3D printing, medical cannabis, stem cells, solar energy, machine learning, self-driving cars — Mother. Fucking. Fusion. These may be the next revolutions in our lives. Even if you correctly forecast the coming changes, turning that insight into money by way of the complex, non-linear investment market is so very hard. It is not the simple cause-and-effect relationship the news headlines would have you believe.

A final story: the physicist had a cat, and wanted to know how it worked. So he took it apart, and he had a non-working cat. Living things are chaotic and complex and it is very difficult to precisely map how all of the inputs lead to all of the outcomes. And the stock market is a living thing. You can easily share in its growth as a passive investor, or try to out-smart it – but that is much easier said than done.

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