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Active vs. Passive Investment Strategies: Which is Right for You?

Academics and investors have debated over the superiority of a passive investment strategy versus an active investment approach for years. First, let’s clear up the confusion surrounding active investing. As fee-only investment advisors we believe “active” is best defined as meaning active risk-management. With nearly 50 years of observing investors, active risk management is the superior approach for two core reasons. The first is due to the “law of large losses” which demonstrates the importance of not losing big. An example of this timeless investment “law” is shared later in this article. The second reason is due to the inability of investors to suffer through the psychological stress or emotional aspects associated with steep price declines. There is no denying that the passive investment strategy has an attraction. This “set it and forget it” strategy is simple to understand and quite alluring. After initial setup there is little time or effort needed to monitor the investment portfolio making the process a relatively mindless endeavor and is supposedly worry-free.

But is any investment strategy really worry-free? If the stock market only went up, passive investing would be easy to stick with…but past painful bear markets teach most assuredly it is not.  Unfortunately a passive strategy designed to capture all of the gains as the market moves higher will also capture all the losses during market declines. Inevitably, as bear markets grind lower and inflict pain, “buy and hold” investors recognize much too late that the approach entails a lot more risk than they first assumed.  Many ultimately do capitulate when losses decimate their portfolio and only sell when the pain and emotional intensity can no longer be stomached.

Generally the passive approach adheres to a fixed asset allocation regardless of changing economic or financial market conditions and that can lead to uneven results.  In fact, the standard passive tactic of re-balancing makes investment decisions automatic but there is a big downside. Re-balancing is the process of, for instance, selling part of a strong performing asset class to add to a weaker one. During major market declines the strategy actually compounds the loss potential by keeping an investor fully exposed during the most volatile negative periods. During bear markets substantial portfolio losses can accumulate in a very short period of time and take a heavy emotional toll on retirees. For instance, the terrifying 60% bear market decline of 2008-2009 lasted a little over one year and wiped out all of the stock market gains of the prior 5 years! Adding further insult to injury for passive index investors it took nearly six years (until 2013) to regain the losses from the 2007 peak: the law of large losses in effect.

Passive investing advocates usually downplay the severity of bear market periods and the effect on investor portfolios and their emotional well-being. In our lengthy careers as fee-only financial advisors we have never met a passive investor that did not feel disillusioned after losing a significant amount of wealth during a bear market.

In fact it can be absolutely devastating. This is critically true if you are a retiree who is in the “distribution phase” of life and tapping into their nest egg for added retirement income. Rather than systematically adding to an investment account during bear market periods and taking advantage of lower prices, you are forced to sell at low price levels in order to withdraw funds to meet income needs. This added hurdle for you should be a real consideration when selecting an investment strategy because it is virtually impossible for retirees to maintain their standard of living if their nest egg suffers significant market losses.

So how important is actively managing risk in order to preserve your capital? The next illustration points out the major fallacy of passive index investing for retirees. Let’s demonstrate the effect by comparing results for a hypothetical retired couple, Mr. and Mrs. Smith. The case study of an initial $1,000,000 investment portfolio with a seemingly safe 5% annual withdrawal by the Smiths illustrates the impact of $50,000 yearly withdrawals ($4,166 each month) during the challenging stock market environment since 2000. If the Smiths retired with $1,000,000 at the beginning of this century, passively invested those funds in an S&P 500 index fund, and took regular withdrawals, they are clearly destined to outlive their hard earned retirement nest egg.

Will the Smiths Outlive Their Retirement Nest Egg?

The combination of periodic bear markets for stocks and steady withdrawals for retirement income leaves the Smiths’ destined to outlive their nest egg.

Now let’s compare results (on the following page) with an active risk-managed approach that emphasizes both a game plan for offense and defense while in retirement distribution mode. During the same difficult period, utilizing Pring Turner’s “all-season” investment process the Smiths would have more money today than when they began with (despite withdrawing the same $837,500 for living expenses over the past 16+ years). Clearly this active strategy delivered on the Smith’s mission to both protect their standard of living and preserve their valuable nest egg.

To achieve these returns we deliberately made risk-based asset allocation adjustments as the economic and financial market conditions changed. For example, bond and cash exposure is increased while stocks are reduced during recession led bear markets and increased during favorable economic conditions. Investment adjustments are made gradually and methodically (we are the antithesis of high frequency traders). As the economic evidence changes, the portfolio changes with the overriding goal to protect your valuable assets through rough periods and grow them in the favorable part of the cycle.

Our results demonstrate the advantage of active and careful risk management around the inevitable business cycle swings. Click Here for an Explanation of our Investment Process. Intrigued with the Pring Turner investment strategy, Dow Jones Indexes, a leading index research organization, analyzed the decision making process and results since 1956. Their rigorous work confirmed the active investment methodology works with favorable absolute and risk-adjusted performance results.  In 2012, Dow Jones launched the Dow Jones Pring Business Cycle Index, the first proactively managed business cycle index for this leading index company. The index was developed as a unique tool for measuring our active investment strategy that dynamically adjusts as the economic landscape changes.

An Active Risk-Based Allocation Strategy

The all-season strategy attempts to both protect and grow the Smiths retirement nest egg.

Of course, no investment strategy is perfect. In fact, our all season investment strategy will from time to time underperform the market especially later in the cycle. That’s because any type of risk management during bull markets tend to mute portfolio returns. But measuring performance over just one half of a cycle (the bull market) only tells one half of the story.

In conclusion, it is essential for all investors to focus on long term performance of any approach through a full bull and bear cycle or more to judge its success.  Even more crucial is to insure the suitability of any particular strategy matches the investor’s particular needs. Any careful review, gauged over long periods of time suggests a sensible, disciplined, active investment management discipline can achieve better returns with less risk. As an added bonus—the Smiths do sleep much easier at night!


Performance Disclosures

CONSERVATIVE GROWTH & INCOME COMPOSITE

Compliance Statement

Pring Turner Capital Group (“Pring Turner”) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards.  Pring Turner has not been independently verified.  

Definition of Pring Turner

Pring Turner is registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940.  The firm offers investment management services to individuals, IRAs, family trusts, corporations, corporate retirement plans, foundations and, as sub-adviser, to other investment advisers.

List and Description of the Firm’s Composite(s)

A complete list and description of all of the firm’s composites is available upon request.

Formal Description of the Composite

The Composite was created on November 2011 and was previously referred to as the “Conservative Growth Composite” up and until October 2011.  It is comprised of fee-paying; fully discretionary accounts managed by the firm without substantial liquidity or investment management constraints. The Composite includes portfolios following our conservative investment style that stresses preservation of capital, income, and growth to attain superior returns with low risk through both good and bad market cycles.  The minimum account size for this Composite is $50,000.

Currency

Valuations are computed and performance is reported in United States dollars ($).  Total firm assets represent the aggregate fair market value of all discretionary and non-discretionary assets managed by the firm and include all fee and non-fee paying assets.  Individual portfolios are valued in a manner that is consistent with the definition of fair value and the GIPS valuation principles.  We do not use subjective unobservable inputs to value portfolio investments.

Presence, Use and Extent of Leverage or Derivatives

The Conservative Growth & Income Composite does not employ leverage or derivatives.

Benchmark

The S&P 500 is our benchmark. The Conservative Growth & Income Composite contains portfolios following our conservative business cycle investment style. Tactical asset allocation decisions, sector rotations, and quality adjustments are made in an attempt to outperform the S&P 500 (on a risk-adjusted basis). Portfolios within the composite are diversified into multiple asset classes (equities, fixed-income, and cash/equivalent investments). The S&P 500 is solely a stock index based on the market capitalization’s of 500 large companies and does not hold any fixed income or cash/equivalent investments. Pring Turner’s goal is to outperform the S&P 500 over an entire business cycle (on an absolute performance and risk-adjusted basis).

The S&P 500 Index is calculated on a total return basis with dividends reinvested and is not assessed a management fee.  “Standard & Poor’s®” and “S&P 500®” are trademarks of The McGraw-Hill Companies, Inc.

3-yr. Standard Deviation

The 3-Year Standard Deviation represents the annualized standard deviation of actual composite and benchmark returns, using the rolling 36-months ended each year-end.

Measure of Internal Dispersion

The Composite’s internal dispersion is measured using an asset-weighted standard deviation of returns in the composite.

Fee Schedule

The investment management fee schedule for the composite is 1.25% on the first $1 Million and 1.00% on amounts over $1 Million.  Actual investment advisory fees incurred by clients may vary.  Further information regarding Pring Turner’s investment advisory fees is described in Part 2A of the firm’s Form ADV.

Bundled Fee Portfolios/Other Fees

Clients employ fee-in-lieu-of-commission brokerage accounts or commission-based accounts.  The fee paid to the broker-dealer covers the registered representatives’ services, brokerage execution, and custody.  Various other fees may also be charged by a broker-dealer and/or custodian (e.g., wire fees).

Net performance figures are presented (a) gross of withholding taxes and (b) net of all investment management fees, custodial fees, trading expenses, and other fees.  Actual investment management fees paid to the firm are used to calculate investment performance.  No account included in the composite has a performance based fee arrangement.

The performance figures include income, realized and unrealized gains and losses.  Performance figures also include foreign withholding taxes on dividends, interest income, and capital gains.

Additional Information

Policies for valuing portfolios, calculating performance and preparing compliant presentations are available upon request.
Past Performance is not a guarantee of future results.
The investment results shown are not necessarily representative of an individually managed account’s rate-of-return.