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Why Current Preferences for Passive Investments Won't Work in the World Ahead

Posted by Don Garman on December 13, 2019

When it comes to your investment portfolio, what happens if the next 18 years don’t look like the previous 18 years or 36 years? Are you financially prepared for a generation where returns are very low?

I believe most Americans are not.

They simply haven’t saved enough, and the passive investment strategy that most people use to invest ⁠— buying market capitalization-weighted indexes ⁠— may not be the best place to be in a world where the future increasingly looks very different from the past.

From the mid-1970s to today, Jack Bogle and The Vanguard Group popularized the movement towards passive investing, which is essentially buying into the largest companies that have done well and have traditionally been successful. But during certain periods of history, such as the Tech Wreck in the early 2000s or the financial crisis a decade ago, this can be a very painful place to be. When you invest in index funds, you’re abdicating the responsibility of differentiating companies from each other and handing that decision to the market. This works when interest rates are declining. But when we look ahead, it’s clear that America is facing one of two scenarios.

The first scenario is where interest rates will stay low because we’re in a massive debt bog and can’t get out of our own way, so to speak, because of pressure from aggregate debt in the system. This is similar to what Japan is currently facing. But this aggregate debt is weighing down society; it’s like trying to run a 10k when you’re out of shape. It’s possible but tough because your body isn’t optimized for it. This scenario promises high volatility and frustratingly low returns.

The second scenario is that we’re in an inflationary cycle where, like the period of time from 1965 to 1982, interest rates will begin to rise. If this is the case, then stocks could be challenged, and bonds will get crushed. Most Americans won’t have any way to combat this because their investment strategy is passive, so they’re likely to sell everything⁠, which will potentially exacerbate both problems, or they’ll try to ride out the cycle, which could destroy their investments.

Topics: Market Outlook, Active Management

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