I love people who are loyal. They stick with you through good times and bad. Unfortunately, when it comes to business, loyalty is dead. Firms will spit you out at a moment’s notice. Banks just move on to the next win once they’ve got you as a customer.

There is no loyalty when it comes to capital. Your goal should be to allocate your capital in as efficient a manner as possible. The more efficient your capital allocation, the greater your chance at financial freedom.

One of the reasons why I keep the comments section open despite the massive amount of spam I must wade through each day is that there are often nuggets of wisdom to be learned.

After publishing the educational post, how online brokerages make money if they cut trading fees to zero, one reader mentioned that Charles Schwab has a promotion where you’ll get $2,500 free if you move $1 million over to their platform. Not bad!

Then another reader chimed in that TD Ameritrade had an even better offer. So I had to take a look.

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On October 2, 2019, Charles Schwab announced that it would no longer charge any trading fees. I remember my father using Charles Schwab in the 1990s and being charged $50 a trade.

Immediately after the announcement, Charles Schwab stock dropped about 9%, while firms like TD Ameritrade and E-Trade dropped by even greater percentages. Clearly, investors in these names were not happy that these companies would be losing a significant portion of their revenue.

But when fees are cut, consumers generally win, if the firms can stay in business. Thus, the question is how will online brokerages make up for this lost revenue? Another question is what should investors on the platform do?

We know from the data that investing in passive index funds over active funds over the long run is the way to go. Over the long run, no rational person would keep on investing in an active fund that regularly underperforms its benchmark, especially if it charges a higher fee.

Yes, despite the logic, active equity funds still account for about 50% of the entire assets under management of all funds. The simple reason is that a minority of active equity funds do outperform their benchmarks. And when they do, there’s hope. We, humans, live on hope.

In this post, I’d like to review the percentage splits for retail investors and passive funds and active funds/individual stocks. I’ll discuss what type of person is appropriate for each of the four splits.

Please do not confuse the percentage split between passive and active investing with asset allocation between stocks, bonds, and other risk assets.

One of the reasons why I left institutional equities in 2012 was because I felt it was a dying business. Not only were trading commissions getting squeezed due to algorithmic trading and other technological advancements, assets under management (AUM) for active money managers was also declining due to poor performance.

Working harder and getting paid less was already demoralizing. Watching my clients I cared about work harder and underperform their respective indices made me feel like my job was pointless. When you feel like your job is pointless, it’s time to do something new.

Since the time I left my day job, the business has only gotten worse for actively managed funds. Yes, it is true that passive money managers gained a tremendous amount of assets during this time period. But there is no excitement speaking to an index fund manager or analyst because they don’t do any analysis. All they do is follow the moves of their benchmark indices. For example, if the S&P 500 removes one name from its index, so does the index fund manager.

As of 2019, the market share of passively managed equity funds has risen to 45 percent according to Bank Of America. For passively managed bond funds, the market share is roughly 25 percent. The market share gains will likely continue.

Let’s look at some active versus passive fund management performance in equities and fixed income over the past 10 years and see what we can discover.

The reason why I prefer owning real estate and starting a business is that I can do things to help improve my chances that the assets will perform.

With Financial Samurai, there’s a strong correlation between the number of articles written and the amount of traffic the site receives. I can spend more time building rapport with readers. I can also write guest posts on other sites to widen Financial Samurai’s reach.

With a real estate investment, I can paint the interior and exterior, refinish the floors, change the fixtures, landscape the front and back yards, expand the livable space, keep up with market rents, find higher-paying tenants and so forth. Then when rates get low enough, I can refinance my mortgage to improve my cash flow.

But with stocks, you and I are minority investors with no say. We are at the mercy of exogenous and endogenous variables. Maybe Trump will announce an all-out trade assault on China. Maybe a CEO will be found guilty of embezzlement. Maybe there will be some type of data breach. Or maybe Amazon or Google will announce they are entering your space.

Who knows!

Yet, investing in the S&P 500 over the long term has proven to be one of the best ways to build a fortune as well. Therefore, all of us should have some exposure to the S&P 500. It’s the amount of exposure that is up to all of us to decide.

Arbitrage is the practice of taking advantage of a price difference between two or more assets or markets, and profiting until the price difference disappears. Being able to recognize and then take advantage of kinks in the system will be one of your greatest catalysts towards financial freedom.

For example, as a elementary-schooler in Taipei, Taiwan, I would buy Nerds candy at the U.S. commissary for 25 cents and sell them to my classmates for 50 cents. Only foreign service families had access to the commissary. But eventually, other candy stores opened and my profits were competed away.

Today, I’ll share with you one of the most obvious arbitrage opportunities. It is an arb that my wife and I are wholeheartedly engaging in because we love free money.

With the 2-year yield higher than the 10-year yield, the yield curve has officially inverted as of 3Q2019. History has shown us there’s a high chance of a recession within the next 6-18 months. I’ll peg the probability at 70%.

To parry a recession, the only thing the Fed can do is to cut rates aggressively from 2.25% down to perhaps 1.6% (where the 10-year bond yield currently hovers) or lower to entice consumers and investors to borrow and get the yield curve closer to normal. Even then, perhaps it’s too late.

When short term interest rates are much higher than long term interest rates, consumers tend to hoard cash and not invest. Why should they when the future looks so cloudy and short-term rates are paying higher than inflation?

Lenders, on the other hand, get squeezed because they have to pay higher short-term deposit rates while earning a lower interest rate on their lending portfolio. As a result, credit standards go up, and even less borrowing and investing occur.

When the velocity of money slows, investment growth, corporate earnings growth, and economic growth also slow. Finally, if enough of us think a recession is on the horizon, then a recession is probably what we’ll get.

With the fear of a recession on the horizon thanks to an inverted yield curve, the stock market has begun to sell off. Due to investor psychology, the S&P 500 generally goes up like an escalator and goes down like an elevator.

If we’re long-term investors, it’s a good idea to understand how much the stock market moves a day on average. When stock market volatility spikes, we’ll feel more calm and reduce our chances of doing something irrational.

Below is a fantastic chart that shows the daily percentage movement of the S&P 500 over the last 10 years. Each dot represents one day.

As you can tell from the chart, the majority of the time, the S&P 500 moves between -1% and +1% a day. Therefore, if you are a long-term investor in the capital accumulation phase, you should consider buying more than your normal investing cadence when the S&P 500 is down greater than 1%.

If you’re in capital preservation mode, you might consider selling some of your S&P 500 index position when the S&P 500 is up greater than 1%.

Of course, nobody knows the future. Trying to beat the S&P 500 over the long run through market timing is unlikely to work.

However, we’re not trying to outperform the S&P 500. What we’re trying to do is figure out how to best invest our cash flow, or larger-than-normal cash injections, during the capital accumulation phase and vice versa.

Here’s another historical average daily percent change chart for good measure.

During the last downturn, I lost about 35% of my net worth. I don’t plan on doing that again.  

Losing 35% is not as bad as the S&P 500 losing ~60% during its worst period, but it still hurt like hell due to the speed and absolute dollar amount of the loss.

Realistically, my target scenario during a recession is to stay flat – neither make nor lose money. But my blue sky scenario is to actually try and make lots of money as the world collapses all around.

Here’s how I plan to do it and how you might too if you’ve accumulated enough money or are planning to retire within the next five years.