Passive Investing Should Be Avoided

'Paradoxically, perfect market efficiency leads to markets becoming inefficient. - Lee Thomas III, Pimco global bond strategist

'It's immoral to let a sucker keep his money. - Canada Bill Jones, 19th century poker player

Investing has many similarities to poker. For example: A small minority of professionals take the lion's share of profits. The house takes its cut from all comers with ironclad regularity.

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Odds allow for confidence, but never certainty - there is no hand that can't be beaten, no hand that cannot win. Both games are heavily influenced by luck in the short run, yet dominated by skill and consistency in the long run. And success is rarely the result of any one large decision; it is rather the result of countless small decisions, built into an accumulated edge over time.

The typical poker player reverts to the style he or she is most comfortable with in live play. This lack of variation gives the professional an edge, highlighting the best way to take the amateur's money. Poker predators usually assign one of three classifications to their prey: Maniac, Rock, or Calling Station. Of these three, the Calling Station is prized as the most reliable source of funds. The Maniac is dangerously aggressive, and often too hot; the Rock is notoriously tight-fisted, and usually too cold; but the lukewarm Calling Station is just right.

A passive aggressive type, the Calling Station has no grasp of strategy, yet feels compelled to participate. He or she is happy to call the majority of bets, rarely raising or taking control of the hand. Analysis is minimal, actions robotic.

The Calling Station's attitude can be summed up as, 'I don't really know what I'm doing, but I'm just glad to be here.'

A streak of good cards will occasionally reward this hapless style of play, but odds inevitably prevail over time. The Calling Station thus provides a steady stream of revenue for those who understand the importance of strategy and put it to use.

On Wall Street, the investing equivalent of the Calling Station is the Passive Indexer - the individual who seeks to unthinkingly mimic the performance of the Dow Jones or the S&P 500. Like his poker equivalent, the Passive Indexer is either unaware that strategy exists or unconvinced of its necessity - just happy to be a part of the action, hoping that luck or providence will provide a decent retirement. (Of course, the Passive Indexer is frequently encouraged to believe that providence is all he needs. This is rather like wolves encouraging sheep to believe the forest is safe.)

By contrasting the modest returns of passive indexing with the subpar returns of mutual investment funds, index touts pull off a neat trick: they make the bad look good by comparing it to worse. Adding insult to injury, many large mutual funds are actually 'closet' indexers, charging for active management yet hugging the benchmarks anyway. This is like starting at the bottom and digging a hole.

In essence, passive indexing is the equivalent of a dog chasing its own tail. Selected companies grow larger as sums of indexed money robotically swell their market caps. As valuations rise, the indexers are encouraged by the boost. The process repeats in round robin fashion, with little thought for the objective worth of the companies receiving these blind inflows.

Few question this puzzling lack of logic, thanks to a triumph of circular reasoning: the Efficient Market Hypothesis assumes that all valuations are intrinsically self-justified. This academic diktat reinforces the torrent of not just dumb, but brain-dead money. Most of us know the crucial economic benefit of a stock exchange is rational and efficient capital allocation, but we forget that rationality presupposes intelligent thought. As passive indexing gains in popularity, the principle of rational capital allocation is turned on its head and thrown out the window.

Those who defend passive indexing invariably point to stocks' historical uptrend. But like the Calling Station on a temporary winning streak, indexers overlook the cyclical tendencies of the market, putting too much emphasis on an extraordinary run of good cards.

Fact is, the market actually spends more time going nowhere than going up, with the typical bear cycle measured in decades. Whether things work out in the long run is a moot point for those with retirement needs close at hand. As Lord Keynes famously noted, in the long run we are all dead.

Alternative asset managers - who pursue absolute returns rather than relative ones - are required to post the prominent disclaimer 'PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS,' or some variation of such, on their investment materials. Ironically, the Passive Index clique relies on just such an outlawed guarantee to make their case. They want you to believe that buy and hold is safe as milk. (In the current real estate climate, 'safe as houses' has lost all meaning.)

Worse still, the indexers lean on history for support without actually consulting it. By ignoring the ramifications of market cycles, massaged data like the Ibbotson study - the most famous bit of agitprop supporting 'stocks for the long run' - proves fundamentally dishonest. A more rational assessment, assisted by data from Rydex.com, would go something like this:

If historical market patterns offer guidance, we are probably heading into a period of sideways to down markets that could easily be ten years or more in duration - hardly the time to be passive.

On the other hand, if historical patterns do not offer guidance - that is to say, if 'this time it's different' and past performance does not guarantee future results - then the case for passive indexing no longer exists.

Is there ever a time to seek general exposure to stocks? Certainly. When valuations are low, pessimism is high, and interest rates and inflation have hit cyclical peaks, it's probably a good time to be a broad market bull. In the stagflated seventies, the PE Ratio for the S&P 500 flirted with single digits, inflation ran rampant, and a determined Fed chairman took interest rates to sky-high levels. Volcker's victory over inflation, and the long march towards price stability that followed, set the stage for the great bull of 1982- 2000.

Here in 2005, we are at the opposite end of the spectrum. Price stability is crumbling. The twin spectres of inflation and deflation lurk. Government expenditures are skyrocketing. The reckless expansion of credit has been unprecedented. Liquidity-driven share valuations cling to stubbornly inflated levels. All these excesses need to be worked off before general conditions can be considered truly bullish once again. A long-term sideways to down cycle is required.

But the news is not all bad. There will be plenty of opportunity afoot, even with the broad markets going nowhere. Savvy investors made good money in the thirties and the seventies, and they will have similar opportunities in the coming cycle. Some sectors will shine even as others languish. There will always be a handful of companies making money hand over fist. Volatility will provide ample trading opportunities on the short and long side alike.

It will be a stock picker's market, and very much a trader's market...but not a passive indexer's one.

By Justice Litlefor The Daily Reckoning

Justice Litle has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr Litle also acted as head trader for a private equity partnership. Now he is an editor of Outstanding Investments. To find out more - plus details of a 90-day trial to the commodity-stock letter that's averaged 72% gains on every recommendation of the last 3 years. The past is no guide to the future. Never risk more than you can safely afford to lose. Foreign shares carry currency risk, and may not be suitable for everyone. You may get back less than the amount invested