Over the last few years I’ve really started to stress an important point in my financial work – the fact that all investment decisions are active even if they are made infrequently or automatically. That is, when anyone deviates from the global cap weighted portfolio they are making active decisions. Likewise, when you automate your process via rebalancing, dollar cost averaging, etc you are making an active decision to streamline the timing of your active investment decisions.
This is important to understand because there is a necessary degree of active and forward looking decision making that goes into any sort of portfolio management. The idea of a truly “passive” portfolio is mythological. No one just sets and forgets a global cap weighted portfolio for hundreds of years. We necessarily intervene at points. This is fine so long as it’s done in an intelligent manner.
But this idea isn’t only true in finance. It is true in government policy as well. Unfortunately, the idea of a “passive” portfolio management style and a non-discretionary policy style comes from the same erroneous economic foundation built by the Chicago School of Economics and believers in the Efficient Market Hypothesis. The basic thinking in these underlying thought processes is that “the market” is smarter than anyone who intervenes. In essence, we can’t “beat the market” because the market is smarter than all of us. On the government policy side this idea is perpetuated to construct the belief that we shouldn’t intervene in the markets because the discretionary decisions will not be as smart as “the market”. But this makes no sense. Even automated policy or “rule based” policy is ultimately a form of “active” or discretionary policy.
For instance, when the economy expands the budget deficit contracts. This doesn’t happen because of some “natural” market force. It happens because we constructed the system in a manner so that unemployment benefits decline and tax receipts increase when the economy is performing better. We call these “automatic stabilizers”, but they are only automatic because we made a discretionary decision to make them automated. This is no different than setting a portfolio to rebalance back to 60/40 every time it hits 65/35. Although the rebalancing might be automated by some technology we chose to implement that rebalancing rule – it is a very active decision that involved an initial degree of discretion.
The ideas of “passive investing” and “non-discretionary” policy are promoted by people who think that “the market” is some all knowing and all seeing entity. These people are almost always anti-government promoters who are trying to use deceptive terminology to convince us that their ideology is correct so that we limit any type of government intervention. But they don’t realize that any decision that intervenes, whether it be automated or not, is very active/discretionary. There isn’t some “natural” course of action that takes place here. There are only the discretionary decisions that market participants make and the effects they have.
Unfortunately, this ideology has perpetuated the myth that any discretionary or active intervention is necessarily bad when the reality is that active and discretionary decisions are a necessary part of adapting and evolving with an ever changing financial system. Our financial lives change and must evolve with the financial system which makes some degree of active investment management necessary and intelligent. Likewise, our financial system is constantly evolving and requires some degree of discretionary intervention. Active management and discretionary policy are not necessarily negative (though they certainly can be). They are a necessary part of any intelligent approach to portfolio management and government policy. Don’t let anyone try to convince you otherwise.