In defense of active investment management

The idea of picking an investment manager instead of investing in an index fund has been taking a beating, lately.

Under the assumption that investors can weather the market’s ups and downs without becoming euphoric or panicking, and assuming that most of them can’t tell a good from a poor investment manager, the case is growing that most people should invest in an index fund and watch better results roll in.

That case has a lot of validity, but it’s important to listen to the other side of the argument, too, in order to pick the right choice for you–the individual.

After all, we don’t all buy GM cars, or buy Apple computers, or eat at McDonald’s. Some people prefer other options. It all depends on what you want to accomplish, how much work you want to put into it, and what your abilities are.

With that in mind, I highly recommend an article by William Smead of Smead Capital Management titled, The Demise of Active Management is Greatly Exaggerated.

Not surprisingly, Smead is an active investment manager who is talking his book (just like most passive/index investors), but he has some interesting points to make and some thought-provoking data to go along with it.

Smead points out that quite a bit of academic data supports the case for investing in parts of the market that aren’t always priced correctly. He highlights that investments in businesses with low debt, high and sustainable profitability, and overall stability can do remarkably better than an index investment. 

Also, index funds market weight their holdings, which means they own too much of the things that investors love best right before they go off the cliff, and not enough of things most investors hate right before they take off–just think about 2000 or 2008. There are other methods for assembling portfolios that work better over the long run.

I’m not trying to make a complete case for active investing, here, but I am trying to point out the other side of the argument. Naive investors may think the case is closed and everyone should be a passive/index investor, when in reality it depends on your preferences and abilities.

Most may be incapable of beating the market, but not all. Most may be unable to pick managers who do better than an index fund, but not all. Most may not want to put the time and effort into doing better than average, but not all. 

Just as most–but not all–people love to eat at McDonald’s, most–but not all–people should probably be passive/index investors. The key is deciding which group you are a member of and thinking clearly about your options.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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In defense of active investment management

2013: tough year for stock pickers

Research from S&P Dow Jones reported in Pensions& Investments shows that 2013 was a tough year for stock pickers.

The average variance in returns between stocks in the S&P 500 was at its lowest in more than 20 years!  That means for people making a living trying to pick the winners and avoid the losers (like, well, me), 2013 looked like a fruitless year.

This is great news for passive, index investors, and bad news for active investors trying to beat the market–at least in hindsight.

This last point is important.  Either the average variance is low and staying there or headed lower, or it will regress to the mean and stock pickers will be able to add value by picking winners and avoiding losers.

My experience is that years like 2013, where most investors are focused on government action, Federal Reserve policy, and international macro-economics, are lousy for stock pickers.  Instead of focusing on sales, earnings, profit margins and returns on capital, investors were trading stocks en masse based on the latest government report.

But, stocks aren’t claims on future Federal Reserve policy or macro-economic output, they are claims on future earnings of specific businesses.  Unless you think all businesses are equal, then some will do better, some will do worse, and buying the ones that will do better will reward you as will avoiding their opposite.

I know what I’ll do as always: spend all day researching specific companies to figure out which ones will win in the years to come.  At some point in the not-too-distant future, this will be profitable again.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

2013: tough year for stock pickers

Stick to your knitting

There are many ways to invest, but, what’s more important than any particular method you choose to is whether you stick to it.

One fundamental choice is passive or active. Passive investing is investing with the market. This method is agnostic about market value and broadly diversified. It’s low cost and tends to beat most active managers, but can go through long periods of poor absolute returns, like we’ve seen over the last 12 years. If you don’t want to search hard for superior investors and can’t stand being out-of-step with other people, then passive is probably your best approach.

Be careful, though, not to waffle between passive and active. More important than your choice of passive or active is whether you can and will stick to your choice. Those who switch between passive and active do worse than those who stick to either passive or active.

Active is investing differently than the general market in an attempt to beat market returns. This is very difficult to do, but if you can find a superior money manager, it can make a huge difference in your long term wealth. Once again, you must stick with the approach for it to work, and this will be hard to do when your active manager is out-of-step with the market, under-performing the market, and charging you higher fees than passive investing. Once again, if you switch back and forth between passive and active, you will do worse than either approach.

Within active, there are several approaches, too. There’s macro investing: trying to bet on economic trends in the attempt to have exposure to the best sectors or countries. There’s market timing: trying to anticipate market sentiment and buy when things go up and sell before they go down. There’s growth: trying to buy the fastest growing companies to beat overall market growth. There’s value: trying to buy companies selling at the lowest price to underlying fundamentals. Value has the best long term performance, but even it goes long periods of under-performance between bouts of out-performance.  

I’m going to risk sound like a broken record, but it’s too important not to emphasize again: it matters less whether you choose value, growth, marketing timing or macro, and more whether you stick to it. Value may out-perform over the long run, but it won’t work if you try to do it when it’s “working” and try to do the other methods when they’re “working.” The academic and anecdotal research on this is unequivocal, people who try to switch methods at just the right time grossly under-perform those who stick to one method consistently.

I’m a dyed-in-the-wool value investor, I’ll readily admit, because it works better than the other options. To succeed, though, I have to stick to it in good times and bad, not just when it’s “working.”

If you want good investment results, pick your method and stick to it. Though some work better than others, nothing works as poorly as trying to switch between them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Stick to your knitting