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This is the latest instalment of our “Ask Wealthsimple” series, where our financial guru Dave Nugent helps you navigate the world of investing.
It seems fairly simple to get great returns when the market is booming, but I’m worried about losses, and ultimately I'd like to outperform the market when I invest. I want someone who’s smart enough to see the end of the boom cycle before it happens so I can avoid losing a lot of money. Is it worth the cost to go to a money manager who can pull that off?
Our basic answer to this is if you're looking for an advisor who can give you a financial plan and help you stick to it, then, yes, that's a fine reason to have an advisor who collects fees. The best way to outperform in a downturn is to have a smart financial plan and stick to it no matter what's happening in the market. But, if you're going to an advisor or manager in order to time the market, you should know that more often than not it doesn't work.
First, let’s define a few things. An active manager is someone who trades in and out of positions, which means she or he buys and sells assets like stocks and bonds on your behalf to try to generate better returns based on her ideas about what will happen in the future. But that service comes at a cost — and managers in Canada charge some of the highest fees in the world.
And then there are passive managers, who build portfolios of diversified assets so investors can hold them over the long term, without trying to predict what will happen in the future.
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There’s a perception among some investors that a good active manager can make you money in a way that is independent of what happens in the markets. They can make you more money when the market goes up, and — this seems to be really attractive to lots of investors — they can get you out of the market before (or even make money in) a big downturn.
While that may be totally possible, we’re not advocates for that way of thinking.
It’s impossible to avoid downturns? That doesn’t seem true.
We’re not saying it’s impossible. What we are saying is that, statistically speaking, it’s not a very successful strategy for anyone to try. The odds are strongly against it working.
A great many economists and researchers have studied the performance of active and passive investing returns. And the overwhelming majority of their results show that it’s very difficult to outperform the market. In fact, most investors end up worse off when they try to time the market.
But couldn’t you find someone who consistently beats the market?
It’s almost impossible to know for sure if any given manager is in that tiny minority — and even harder to predict how any given active manager will perform in the future. Even a manager’s recent performance has little if any predictive value of future performance. In any given period of time, there will be a number of active managers who will beat the market. Those same advisors may also do worse during another period — it’s just a product of statistics, not genius.
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All the research tends to say the same thing: even the most expert investors in the world are unable to time the market, i.e., predict it with the degree of accuracy that would be necessary to make this a part of a deliberate long-term investment strategy. In fact, most active managers would likely argue that market timing is very hard to do and would not advise trying.
And, even the best active managers know that even if they outperform the market they can’t necessarily help avoid a downturn.
Why do so many people have confidence in their “financial guys,” then? I hear it again and again, “My guy is the best.”
Ironically, a lot of this way of thinking is the product of people doing really well during bull markets. Often, investors who make a lot of money during bull markets think they owe their performance to their “active” manager (i.e., their “financial guy”) — though studies have proven that people who pick stocks are usually no better at it than a monkey throwing darts. In a very few cases credit may be warranted, but it’s almost impossible to know for sure.
Again, it’s important to distinguish between people who try to beat the market and people who help you devise a sound financial plan and stick to it. One of the best things a financial advisor can do — after they’ve determined the best asset allocation for you — is a little behavioural coaching. Like reminding you not to panic during a downturn because downturns are normal, “don't panic!” or “This is normal!”, or not to go overboard when your investments are doing well.
Is there any advantage to passive investing other than avoiding people who incorrectly guess what’s going to happen in the market?
Yes. That advantage is lower costs and fees.
Most investors who use active managers would probably have done even better if they had invested passively — bought stocks and held them — throughout the exact same market. Why? You can’t control much when you’re an investor other than your own behaviour. But what you can control are costs, taxes, and fees. Active portfolios have higher costs, taxes, and fees, which eat into your returns. And those costs magnify over time. Every extra dollar spent on those higher costs is a dollar that doesn't compound in the future.
I’d still like to think there are ways to set yourself up to perform a little better in a downturn. There has to be some ways to mitigate the risk.
There are definitely ways to mitigate risk, and there are strategies that help. All well-built investing portfolios should do that work for you, largely through diversification. For example, in a lot of scenarios when stocks are doing badly, U.S. government treasury bonds are still going to do well. That tends to make the troughs less steep, provided you’re holding both investments in the right proportion. Other ways include choosing higher-quality stocks, or weighting stocks by risk rather than by market capitalization. Good passive portfolios should have those methods built in.
Bottom line: advisors are at their best when they're helping people make smart holistic financial plans and helping their clients follow those financial plans through good times and bad. They can also help investors stay away from a lot of active strategies that probably won’t work.
Market timing, however, just isn’t something anyone does well, and it isn’t something any investor should be trying to do.
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