Portfolio management
Intelligent patience to sit tight
If you search ‘active investing’ on the internet you can find definitions like this: “Active investing. This is a strategy that involves a lot of buying and selling of investments with the goal of beating the market.” And, a lot of investors think this is what it means. They couldn’t be more mistaken.
Here’s a milder version from Investopia: “Active investing requires a hands-on approach, typically by a portfolio manager or other so-called active participant. Passive investing involves less buying and selling and often results in investors buying index funds or other mutual funds.”
Inactivity
Warren Buffett says: “Inactivity strikes us as intelligent behavior.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p.89. (emphasis added)
When I say that ‘active investing’ is an oxymoron I simply mean that ‘investing’, well-conceived, involves inactivity rather than activity.
Investment philosophy
The level of activity in your portfolio will reflect your investment philosophy. The following ideas come from Warren Buffett. It’s the approach I try to follow:
- Keep it simple.
- Invest only in superb companies. Look for the seven footers.
- In evaluating companies study the long term business prospects of companies you are considering investing in and purposely underweight the ‘vistas immediately behind you’.
- Buy shares only in companies whose earnings are virtually certain to be materially higher five, ten and twenty years in the future. There is a normal lumpiness to the earnings of even the best companies. The only earnings that grow steadily are those that are ‘managed’ (in the bad sense) by the CEO and CFO.
- When buying shares view the purchase as though you are buying into a private business.
- Expect that the bargain you buy may take several years to become fully priced
A few quotes
Warren Buffett wrote in the Berkshire Hathaway Chairman’s letter for 1988: “In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.”
Lefevre writing in the 1920s tells us in the words of the colorful but also wise Jesse Livermore: “Men who can both be right and sit tight are uncommon. I found one of the hardest things to learn”. He goes on: “The reason is that a man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figured it must do. That is why so many men in Wall Street, who are not at all in the sucker class, not even in the third grade, nevertheless lose money. The market does not beat them. They beat themselves, because though they have brains they cannot sit tight. Old Turkey was dead right in doing and saying what he did. He had not only the courage of his convictions but the intelligent patience to sit tight.” (Lefevre, Reminiscences of a Stock Market Operator. 1923,1993) p.69.
As a practical example, let’s look at my activity in the last year, which is typical. I currently hold 13 stocks. I sold two in the last year and replaced them with two other stocks, better I hope. I also added one stock. My portfolio looks very much like it did five years or ten years ago. The average holding period is well over 5 years.
Passive investing
Index fund investors are the only investors who can pursue a simple passive buy and hold strategy. An investor can, during his working life, regularly put savings into a low fee S&P 500 indexed mutual fund or a low fee S&P 500 indexed ETF and hold them for the duration. By the duration I mean not only until they retire, but also until the end of their days. This would produce a satisfactory return.
In his 2013 annual letter to Berkshire Hathaway shareholders, Buffett explained the advice he gave to the trustee for a bequest to his wife in his will: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 Index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors–whether pension funds, institutions, or individuals–who employ high-fee managers.”
As an aside, I would note there is a world of difference between an index fund buy and hold investor and the investor who uses index funds to try to time the market by switching back and forth between an index equity fund and a bond fund, or between varieties of sector or theme index funds.
Active investing using ETFs is a loser’s game
With the emergence of ETFs passive investors have the opportunity of investing in index tracking funds that can be traded on the stock exchange. As with mutual funds, ETFs have seen a profusion of specialized funds emerge that encourage ETF investors to practice sector and theme rotation and market timing. Even though both mutual funds and ETFs were originally meant as vehicles for passive investing, it is entirely possible that investors using all of the specialized and segmented funds available today are practicing just as much or even more market timing as they ever did. The inevitable consequence for these investors is the behavioral gap – the typical investor will underperform the funds they invest in.
Active investing using ETFs is also a growing losers’ game.
To give you an idea of the popularity of these fancy ETFs, here is a chart from Morningstar showing the popularity of two kinds of ETFs. It may not include Factor ETFs which I consider to also be active investment products.
Conclusion
I don’t know where the terms active investing and actively managed funds came from. I suppose they have been thought to distinguish the first from simply investing your savings in an index fund and leaving it there. Even putting your money in an index fund is a form of active investing. The components of the index change from time to time. There are asset allocation decisions to make. My point in this post is to simple note that intelligent investing at its heart is quite passive. Traders and speculators are another kettle of fish.
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To read a little further into the active vs passive debate and where DIY investors stand, check out these posts:
DIY investors are not the patsies at the table
The rise of passive investing and opportunities for active investors
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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