Why it makes sense to become a defensive (passive) investor

Published: December 19, 2021 at 7:00 am

In this article, SEBI registered fee-only advisor Swapnil Kendhe explains why it makes sense for most of us to become defensive (passive) investors.

About the author: Swapnil is a SEBI Registered Investment Advisor and part of my fee-only financial planners’ list. You can learn more about him and his service via his website, Vivektaru. In the recently conducted surveys of readers working with fee-only advisers, Swapnil has received excellent feedback from clients. See:

This is his story: Becoming a competent & capable financial advisor: My journey so far.

Here are some of his previous articles:

Benjamin Graham makes a basic distinction between two kinds of investors in his book The Intelligent Investor – the enterprising (or active, or aggressive) and the defensive (or passive).

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“The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average”.

“The defensive investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions.” – Benjamin Graham.

Investing directly in stocks, trying to find the best performing fund, PMS or tracking markets, following the news, constant monitoring and changes in the portfolio are enterprising investor activities. The primary focus of an enterprising investor is on generating above-average returns.

The defensive investor creates a permanent portfolio that runs on autopilot and requires little further effort. He thinks long term, prefers low maintenance products like index funds for equity. See –  The arithmetic of index investing explained.

He keeps credit, and interest rate risk low on the debt side, diversifies the portfolio instead of over-relying on one asset class, keeps costs low, maintains asset allocation that lets him sleep well at night, and trusts rebalancing more than market timing. The defensive investor values simplicity, minimal oversight, and peace of mind more than the return. He doesn’t want his investing to interfere with the rest of his life.

Since the enterprising approach is the more talked about approach of investing, knowingly or unknowingly, most investors do enterprising investing. But do they do it successfully?

Successful enterprising investing is generating a higher return than the return that an investor can generate by following the defensive approach, at the portfolio level, over the long term, and post taxes and expenses. To do that, an investor needs two things: excellent knowledge of investing and a lot of time.

We are talking about fund manager level knowledge here. Most investors don’t have that knowledge. While knowledge gives an investor a framework to do enterprising investing, knowledge alone is not enough. Along with knowledge, he needs significant time for the research. If an investor lacks any of the two: knowledge or time, enterprising investing is unlikely to work for him. Such investors should follow the defensive approach.

Even for an investor who has the required knowledge and time for enterprising investing, the defensive approach makes sense unless he is an investment professional or he doesn’t have any interest outside investing. This is because there are no guarantees in enterprising investing. There is always a risk that, after spending a significant part of life doing enterprising investing, the investor may underperform a defensive investor’s portfolio.

Time is a finite resource. Why waste it trying to extract a few percentage point extra return from your investment portfolio. There is so much more to life. I am a financial planner. I have read most of the well-known investing books. But I don’t want to do enterprising investing in my portfolio. Given a choice to read a good investing or non-investing book and an annual report, I would always pick the former. Reading a great book makes me happy. Do I really need to spend that time researching stocks or markets? My index portfolio, anyway, captures the market return for me. I don’t see any sense in sacrificing some of my other interests in life for a potential higher return.

If investing is not your profession or if you don’t want to put plenty of time and energy into investing, the most rational thing for you to do is to follow the defensive approach, free up your mind away from investing, and focus it on self-actualization.

Have ambitions in your profession. Try to become a top person in what you do. Top people in all fields make money. Superior investment return is not the only path to creating wealth. If you have a high savings rate, you would accumulate enough assets to take care of all your financial needs. Fretting over return is pointless.

Investing books like Basant Maheshwari’s ‘The Thoughtful Investor’ get investors fired up to find and hold multibagger stocks; but for most investors, the impact of such books doesn’t last for more than a few months. Soon, they are busy with their professions and forget about stock investing. In a year, they don’t even remember why they had invested in stocks they hold. There is no point in doing something one cannot do consistently and correctly over the long term.

How about paying an adviser to help you do enterprising investing? The problem is, it is really difficult to find an adviser who can actively manage your portfolio successfully. There are too many advisers who don’t beat a defensive investor’s return in their clients’ portfolios while extracting massive commissions or fees for themselves.

Advisers who probably did enterprising investing successfully in their clients’ portfolios in the past, may not do the same in the future. Past performance is a terrible predictor of future performance in investing. Investing is not chemistry where when you mix compound A with compound B, you always get compound C.

In investing, mixing A with B might have gotten you C in the past, but there will be a range of possibilities when you do the same in the future. There is a lot of guesswork, judgement calls and luck involved in enterprising investing. The adviser may do his job sincerely and still fail to help you better a defensive investor’s return.

Advisers who actively manage client portfolios are also likely to charge a percentage of assets fee. There is also higher tax outgo because of active management of the portfolio. Even if advisers generate some alpha for you post-tax, it may not cover their higher fees.

Another problem with the percentage of assets fee is that the adviser doesn’t put 10 times the effort to manage a 10-crore portfolio as against a 1-crore portfolio. It is unfair to charge a 10X fee to the 10-crore client. Fixed fee advisers who recommend the defensive approach are offering a much better product at much lower fees. See: Should I pay a financial planner who only recommends index funds?

Barring a small percentage of investors born with the right brain-wiring required to do successful enterprising investing, the defensive approach is what everyone else should follow.

But though simple, defensive investing is not easy. To fully appreciate its virtue, one needs a good understanding of four broad areas William J. Bernstein talks about in his book ‘The four pillars of investing: the theory of investing, the history of investing, the psychology of investing and how the financial industry operates.

To quote Jason Zweig, “The passive or defensive strategy takes little time or effort but requires an almost ascetic detachment from the alluring hullabaloo of the market”. Markets are too seductive for most investors to do that without the help of a competent investment adviser, who has studied investing enough to believe in the defensive or passive approach and has intellectual humility and intellectual discipline to stick with it and not do anything clever.

You can contact Swapnil for your financial planning needs via his website, Vivektaru.

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