What’s Your Tolerance for Complexity?

“Being passive doesn’t mean doing nothing.” – Larry Swedroe

One of the first decisions you need to make in the process of building an investment portfolio is whether you will be an active or a passive investor.  Most investors assume this means making the choice between index funds and active management, but that’s too much of an over-generalization.

In my mind, the active versus passive decision actually comes down to the amount of time you are willing or able to put into your investment process, not necessarily the particular strategy you utilize.

It’s not just about choosing the best portfolio process that fits your personality and skill set.  Time management also comes into play.  Plus, investing is hard.  As much as I love nearly every aspect of the financial markets, you have to have a life too.

Larry Swedroe shared some interesting thoughts along these lines in a recent Seeking Alpha post:

As a passive investor, when I come home from my busy day, I get to sit down with a glass of wine and ask my wife about her day and how my kids and grandchildren are doing. Because I didn’t spend my time trying to beat the market, I also got to coach my youngest daughter’s softball, soccer and basketball teams. I also read 50 to 70 books each year, do community service, play tennis, and focus on the other really important things in my life.

Investors following an active management strategy spend much of their precious leisure time watching the latest business news, studying the latest charts, reading financial trade publications, and so on. Even if they are among the few who are successful at the active management game of generating alpha (performance above risk-adjusted benchmarks), the “price” of success may have been that they lost the far more important game of life.

I like to think about this in terms of your tolerance for complexity.  You have to ask yourself a few questions when thinking about the implementation of your process to see if a complex or simple strategy is right for you:

1. Do I have the time required to pull off an active strategy and follow nearly every development in the markets?
2. If so, do I have the right strategy and a process that will allow me to make high probability decisions in an active construct?
3. Can I handle the stress that comes from making so many short-term portfolio moves?
4. Do I have an edge over the rest of the market participants?
5. Is the payoff really worth it for me to put in the time and effort?

I don’t think there’s a one-size-fits-all strategy for every single investor out there.  It all comes down to what works best for your personality that can increase your probability for success and minimize unforced errors.  I have my views, but there are many investors out there that I know and respect that have a different way of doing things than I do.

I do feel that the biggest advantage individual investors have over the professionals is the ability to be patient, think and act long-term and do nothing the majority of the time. Patience along with a systematic plan that focuses on the long-term can be a wonderful combination with the correct behavior.  The point is to create a rules-based, repeatable process that you can use to make decisions under a wide variety of market environments.

Most investors assume passive strategies are set-it-and-forget-it and see what happens. Actually, the biggest difference between active and passive strategies is the timing of the investment decisions.  Most active strategies generally require using the latest data to make a series of shorter-term decisions based on changing market dynamics.  Most decisions are being made in real-time while trying to out-think the crowd.

Passive strategies are also active in many respects, it’s just that they require you to actively not make short-term moves.  In some ways, this is more difficult than continually making changes to your portfolio.  Think of passive strategies as a way of outsourcing your future decisions by crafting a set of long-term principles up front.

Of course you will have to make the requisite corrections along the way as your risk profile and time horizon evolves, but the hope is that it frees you up from being in a constant state of worry.  The biggest benefit of having a set process is you can let go of short-term outcomes that are mostly out of your control so you can live your life without stressing about every minor gain or loss. If done correctly, it allows you to live your life and still grow your money.

Even taking out the short-term active portfolio decisions isn’t enough for many that don’t have the required abilities to be a successful investor. If this is the case, the other option would be to hire a trustworthy financial advisor that can handle the heavy lifting for you to free up your time and help you sleep at night.

Whatever route you choose, just remember that financial decisions don’t always come down to numbers.  Money evokes powerful emotions and there are many other considerations that can’t be quantified.

Living a happy life is typically the ultimate goal for investing and wealth-building.  As with most money decisions, your investment strategy should take into account the need for a balance between ensuring a comfortable future and happiness in the meantime.