Are actively managed portfolios guaranteed to underperform passively managed portfolios? That’s what William F. Sharpe argued when he wrote The Arithmetic Of Active Management.
The idea is quite simple, and the paper is quite short if you’d like to read it.
It presents a very simple argument for low-cost passive investing versus high-cost active investing.
Through simple arithmetic, Sharpe argues that it’s easy to see that passive portfolios will outperform active portfolios. The argument is built on a few simple concepts so let’s take a look…
There are a lot of risks that we face in retirement (including early retirement). When you enter retirement, there are lots of changes happening all at once. Along with big personal changes, and lifestyle changes, there are also big changes happening to your finances. After you enter retirement one of the biggest financial changes you’ll face is a shift from a regular income source (eg. employment) to an income source based entirely on your own savings and pension. Making this switch can create a few risks, one of those risks is the risk of running out of money.
One of the biggest risks facing retirees is something called sequence of returns risk. When a good portion of your retirement income comes from your own savings this is the biggest risk a retiree can face. But what does “sequence of returns risk” mean exactly?
Before we talk about sequence of returns risk it’s important to understand that most retirement plans are based on an assumed (and constant) investment return each year. This investment return is usually assumed to happen in a straight line with the same percentage return each year. An assumed return of return of 5% would be 5% per year starting on the day you retire, but in reality your investment return is going to fluctuate from year to year, and this is where the risk comes from.
Over the short-term you will probably see your investment return fluctuate greatly from year to year. Instead of seeing investment returns of +5%, +5%, +5%, +5%, +5%, you might see +20%, +2%, -10%, +15%, +1%. In this case the average return is still +5%, but there were some huge swings from year to year. “Sequence of returns risk” refers to this sequence, the actual investment returns you see year after year.
The big risk for retirees happens when the sequence is negative for a few years in a row. Even if average investment returns recover over the long-term, that short period of negative returns can have a devastating effect on a retiree’s portfolio.
In general, there are two types of investing, passive investing, and active investing. Passive investing means purchasing broad index funds that will match market returns at the lowest possible cost. It means focusing on the aspects of investing that are directly in the investors control like investment fees, asset allocation, and diversification.
Active investing, on the other hand, means purchasing specific investments with the hope of outperforming the market over the long run. Active investing can be very appealing and very exciting, but it has its risks. When you’re an active investor there is the possibility of beating the market return and growing your portfolio substantially over time, but there is also the possibility of losing everything.
The issue with active investing is that it generally doesn’t deliver. After investment fees, time, effort etc., the active investment portfolio typically does not outperform the market. In fact, individual investors are known to be very poor active investors, trying to time the market, putting all their eggs in one basket, taking on too much risk etc. etc.
As we’ll see, even the pros don’t have a great track record with active investing. Over a long period of time the majority of actively managed funds fail to outperform their passive peers.
Despite the risk of lower returns, active investing is still very appealing for many investors.
So how do you get the benefit of passive investing with its low fees, high diversification, more consistent returns, and still have a bit of fun with active investing?
The solution is to allocate a small portion of your portfolio to active investing. Basically, the idea is to create your own personal “hedge fund” with a portion of your portfolio. It’s a small amount of money which can be more actively managed without risking your entire nest egg. But how do you do this properly and without risking the rest of your portfolio?
One amazing thing to consider about personal finances is the sheer amount of money that will flow through our hands over a lifetime.
Knowing how much money we’ll touch over a lifetime provides a very good incentive to get better at managing income and spending, to learn more about investing, to understand how income tax works etc. etc.
Given the amount of money we’ll handle over a lifetime, learning more about personal finances will pay dividends over many years. If you’re able to manage money well, then you’ll have a life that is free from financial stress (for the most part, it’s never possible to completely avoid financial stress).
Because of the sheer amount of money that will flow through our hands over a lifetime even a small positive change can have a significant effect.
So how much money will we “touch” over a lifetime… is it $500,000? $1,000,000? $2,000,000? $5,000,000? You might be surprised…
If we knew how things would unfold in the future, then financial planning would be easy.
If we knew things like future investment returns and future inflation rates, then that would remove a lot of uncertainty in a financial plan.
If we also knew when we’re going to die, then we could make sure that we spend every penny and “bounce the last check”.
But because of all the unknowns, we have a lot of uncertainty within a financial plan. To create a great financial plan, we have to evaluate and plan for that uncertainty. We have to understand both the average and the extremes. We don’t want to run out of money in the future, so it’s important that we manage this uncertainty properly and avoid making bad assumptions.
Life expectancy is one of those assumptions and it’s a big assumption within a financial plan. Assume a life expectancy that is too short and there could be years (or possibly decades) of meager retirement income.
When it comes to life expectancy, we can’t just assume the average, we need to know how much longer our money needs to last. Is it 5-years past the average, 10-years, 20-years, or more? Hopefully it’s for a very long time.
Getting married is a big step in a relationship. It often means changes to personal finances. Some of these changes can be quite positive. These changes can actually make it much, much easier to achieve financial goals.
In this post we’ll explore the financial benefits of marriage (or entering a common-law relationship).
There are obviously a lot of considerations when combining finances, but there are certain financial advantages that couples have versus individuals. These advantages can make it easier to achieve financial goals. There are tax advantages, saving advantages, spending advantages, debt advantages, and risk reduction advantages.
If you’ve recently entered into a common-law relationship, or if you’ve recently gotten married, then you might be interested to know the financial benefits of marriage.