The Edge Provided by Active Management
Whether we realize it or not, studies show that mass marketing has a tremendous impact on us, especially if we are investors. It seems that every week I hear a market expert touting the benefits of long-term passive investing. While returns from passive investing have clearly proven to be anything but reliable, Wall Street’s propaganda machine continues the drum beat of “buy-and-hold is the only good way to invest.”
Investors are usually shocked to learn that most industry professionals and their firms actively manage their own portfolios while they continue to discourage their individual clients from doing the same. I see it as a lack of commitment on their part. A passive buy-and-hold strategy is cheap and easy to deliver. It is more expensive, time consuming and requires a higher degree of skill to provide clients with advice that requires action in response to market conditions. Most investment firms are simply not willing to put forth the necessary effort to provide for their clients’ investments like they do their own. Instead, they recommend what is easy, the road most traveled; the same one down which the vast majority of investment firms send their investors – I call it the road of buy-and-hope.
While investment firms claim to be independent, the investment philosophy they sell is often the same. The benefit, of course, is that when things go wrong there’s comfort and job security in being part of the crowd. How many financial advisors have been fired for holdings in GE, Microsoft, or Pfizer, despite 50% losses over the past few years? Not many. Misery loves company.
Another reason mainstream investment firms tout buy-and-hold has to do with their ability to sell the concept. A simple concept like buy-and-hold-forever is easy to sell compared to the more complex active management approach, focusing on risk management. The faster they can sell one client, the faster they can get to the next one. These firms are in business to make a profit, and their time is money.
Investing Only With an Offense
Being part of the buy-and-hold crowd is like playing a football game with only half the team on the field. What if you were the owner of a football team that was limited to fielding only an offense – no defense! How likely would it be for your team to be successful over the course of the season? Investing is like football, in that the winners normally play good defense as well as good offense.
Unfortunately, this one-dimensional approach is what many investors are doing today. They have been convinced by promotions that an investment designed only to profit in bull markets will ultimately bring them success. They’ve been taught to ignore the fact that they have no way to profit or protect their assets during declining markets.
Looking at the last 20 years, you might be surprised to learn that, on a daily basis, the stock market finished down 48% of the time! This is one reason that prudent investing requires a defensive plan as well as an offensive plan.
When to Use a Passive Approach
In what areas of your life do you normally pursue clear goals with a passive solution rather than an active one?
How about in raising your children? Is it a good idea to be passive? Not really.
How about in advancing your career? Would it be a good idea to be passive while attempting to climb the corporate ladder? Probably not.
Well, how about on the athletic field? Would a passive approach work in your favor? Of course not. Rarely does an athlete with a passive attitude succeed.
Why is it then, that so many financial professionals promote the idea of passive investing? It’s beyond me.
Passive Investing is Less Predictable
The passive approach to investing is doomed to fail at some point, as Nobel Prize winner Paul Samuelson told us: “the longer one holds a stock the more certain it becomes that he will encounter a significant market upheaval. Risk does not go down with time, it goes up!” Time brings greater price fluctuations. Passive strategies continually expose assets to market fluctuations and disappoint investors when markets decline. Passive strategies attempt to ride out the declines, betting that markets will be higher not lower when the investor needs his or her money. If betting is what you want to do with your savings, then perhaps passive buy-and-hold investing might be OK.
The Edge That Active Management Provides
Although there is no perfect investment strategy, no silver bullet, and no guru who always gets it right, strategies that Adapt to Changing Markets® all have one thing in common. They strive to provide investors with an edge on the market they would not enjoy with a passive buy-and-hold style.
This edge can be as simple as selling investments and moving to cash in times of uncertainty, only buying investments that are going up in price, or following pricing patterns that have had some success as predictors of future activity. There are many different styles of active management each pursuing a different advantage.
Diversification means not keeping all of your eggs in one basket. Having only one strategy for investing is much like only owning one stock. Lack of diversification increases ones risk.
Having investments that can Adapt to Changing Markets® is clearly sensible and safer. Remember that passive buy-and-hold strategies work pretty well in rising markets – but they always fail during falling markets. Buy-and-hold investing is like any other from of gambling; eventually your luck runs out.
Active management means making decisions. Your decisions won’t always be correct, but that doesn’t mean you shouldn’t keep trying to do what is right. If you are uncomfortable making these decisions for yourself, consider hiring an active money manager to oversee your portfolio for you. You aren’t passive about other areas in your life in which you hope to excel – investing should be no different.
From the Financial Market Review, November 2004 (c) William T. Hepburn