Sunday, February 07, 2010
Yesterday a reader left this link from DealBook about Burton Malkiel's thoughts on active management along with the other side of the discussion as observed by James Tierney from WP Stewart, and active manager running a very concentrated portfolio with an outstanding track record versus the market going back to the 1970s.
You've heard the basics of Malkiel's argument before; no one can consistently pick winning stocks and no one can consistently time the market. In addition to the difficulty Malkiel also notes the problem of human emotions getting in the way. I imagine the argument in favor of active management is not new to you either. Among other things mentioned the active managers say that there are people who can consistently beat the market.
Malkiel also says the fees are too high but the active managers say a good manager is worth it. Perhaps in defense of the fees it seems as though the active managers were saying that they can tailor a portfolio to the client's needs and do so successfully. The debate in the article finishes up with Malkiel saying things like hedge funds are a better deal for the managers than the clients ("where are the customer's yachts?") and the active guys apply the superior ability to pick stocks into a defense for why exotic products do make sense for some people.
So on the one hand picking stocks that beat the market with consistency cannot be done and on the other hand "we" consistently pick the right stocks and have been doing so for a long time. This is always a good debate. I hate to tell the people who say it cannot be done but if someone has a track record for success of beating the market going back to the 1970s there is a good chance they are on to something. However it is just as true that not everyone can be above average and I am sure there are far more people that lag the market over long periods of time than beat it but I assure you WP Stewart is not the only company to have a stellar track record going back that far.
The above is all well and good and you will read about it again and again but it is completely the wrong context for the vast majority of investors. As I type that thought I know there will be comments from people who are focused on beating the market but again it is completely the wrong priority for most people.
An investor's top priority (repeat theme coming) would seem to be having enough money when they need it. What good is it to have soundly beaten the market for 20 years right up through 2007 with plans to retire in 2009 only, because of hubris from 20 years of beating the market, get hit worse than the market in 2008 and panic out at the low. Obviously an extreme example and you might be thinking about proper asset allocation but often hubris overcomes the logic of a proper asset allocation.
In addition to having enough for whatever the goal is (we're probably talking about retirement) I can tell you that there are all sorts of "one time" events that come up either as a function of an unrealistic understanding of what can be spent or a genuine emergency where money must come from the portfolio. One of these events coming at the wrong time, like last spring, can be impossible to recover from. Impossible that is unless something else gives.
The concept of life events happening makes the argument for smoothing out the ride or as John Serrapere puts it 75/50. To Malkiel's point about emotions getting the better of us; couldn't that be spun into an argument for the exact type of defensive action I talk about so much? After all when is an investor most likely to be overtaken by emotion and do the wrong thing in their portfolio? Wouldn't that point come for many people somewhere between down 30% and 50%? Maybe 20% and 40% but if we can't control our emotions then it seems logical to try to avoid putting ourselves in the position where we might succumb to emotion?
Given the argument I lay out above, I think the thing that matters is smoothing out the ride as much as possible. Avoiding parts of the market where there is obvious trouble, like Western Europe and the US financial sector over the last couple of years and for now we can add financials in China and long dated US treasuries, and favoring areas with some obvious tailwinds (was choosing Brazil really impossible to do five or six years ago?) is a way to do this.
If you don't think you can do this then maybe you shouldn't but it is not impossible to do especially when you realize that all this does, in the context I mean, is put the odds in your favor but there will be times where you are wrong. For normal active investors a career is some combination of correct and incorrect decisions that hopefully add value. Adding value does not have to mean beating the market every year. A month and a half ago I put up a post about a fictitious manager who lagged the market every year of the bull phase but got out in time thus coming out way ahead for the cycle. In that post I asked if lagging for five years but coming out 30% ahead for the entire cycle was a beat or not.
When you realize ahead of time that there will be bear markets, that you will not always be correct and think about the long run success of having enough when you need it you have a much better chance of doing well whatever that means to you. But the idea of picking a bunch of stocks to beat the market this year and then start over again next year makes the task more difficult. Convincing yourself not sell after you've ridden the market down for 40% also makes the task more difficult. I prefer to make the task simpler.