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April 19, 2011


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Investing is a lot like betting on a horse race. A good better will check the odds, handicap each horse and through experience bet the horse they think will win. It's a lot of work and will doubtful results. Sure a knowledgeable gambler will win on average but not without a lot of trouble. To win every time why not bet on all the horses. You can't lose. This is how index funds work. Your owning the entire stable of stocks, some will win some will lose, but you will mostly win. If your not able or willing to do the handicapping on your stocks, it's the way to go.

The "mutual fund managers can't beat an index for long periods of time" argument is a bit of a red herring. Yes, they probably have better research, but fund managers have lots of constraints individual investors don't have - having to deal with inflows and outflows, being constrained to investing in particular stocks to fit a "style" or sector, having to buy and sell huge lots, being fully invested all the time. They also have an incentive to increase volatility to try and get to the top of the league table - if they consistently beat the index by 1% a year after expenses, they'll never appear in the "top 10 funds of 2010" lists. Being at the top of the list creates huge inflows and makes you rich.

Individuals can thus have a huge advantage. Feel like everything is overpriced? Sit in cash for 6 months. Want to get into a small company without moving the price? No problem.

Wholly agree that it takes discipline, time, and the development of certain skills to consistently beat the market; that fund managers don't isn't evidence that it's not possible for individuals.

You can be the smartest person in the world, but all it takes is a natural disaster or a failed pharmaceutical trial, and your profits/investment can evaporate in the blink of an eye (in an individual stock).

Most of my money is in index funds.

I think that this topic was written for me since I became an active investor soon after I retired.
I have an intense aversion to losing money. I think it is because of my upbringing and early life in England during WWII. Everything I have is the result of my own hard work and effort. I didn't have parents that were in a position to send me off to a prestigious university when I graduated from high school like many that read this blog. I had tremendous grades when I left high school but, even with a scholarship. the university was out of the question for me without parental help - and there was no possibility of that.

What did I do! In 1951 I put on a pair of blue overalls, became an indentured aircraft apprentice for 5 years at a pittance of a salary. Even with a tiny salary I gave 2/3 to my mother to help out. I got my hands dirty running lathes, shapers, milling machines, drill presses, and making sheet metal parts while my employer signed me up for attendance at a municipal college, one day/week and every evening, taking courses that would eventually lead to a Higher National Certificate in mechanical engineering. This was equivalent to a university degree but with all the subjects that didn't directly apply to engineering stripped out. I did so well in these courses that my employer soon switched me from being a trade apprentice to becoming an engineering apprentice. Gone were the overalls and the dirty work, now I could go to work in a suit and tie and rotate through all of the engineering departments such as Design, Aerodynamics, Structures, Thermodynamics, Metallurgy, Test Labs etc. etc.

The day after my apprenticeship ended my new wife and I stepped on an ocean liner thanks to a Canadian aircraft company paying all of our expenses to get to Toronto and work for them as a junior stress engineer for $83/week. Not long after that we emigrated to America and we were well on our way to an exciting and bright future with our expenses paid to Northern California with a job at Lockheed Missiles & Space Co. where I spent my whole career, earning my MS in engineering mechanics in 1963, paid for by Lockheed, and retiring in 1992 as a Senior Staff Engineer earning $1,394/week. My complete education cost me nothing other than buying books.

The spark that lit my interest in "Smart Investing" was an ad in the Wall Street Journal from a small company, founded in 1987, that maintained a database of mutual funds that also came with charting and analysis software. In particular it was a method that used a pair of mutual funds and traded from one to the other based upon relative strength. You started off buying the strongest fund and held it until the method showed that it was time to switch into the other one. This concept of using a trading pair worked very well with the Fidelity Select funds and the company's software made it very easy to backtest various trading pairs representing different market sectors and to vary the switching parameters until you found the optimum settings that maximized the return while minimizing the number of trades. Popular sectors back then were Finance, Healthcare, Technology, Energy, and Food & Agriculture. When the economy was doing very well certain sectors also did well, when the economy was doing poorly then the more defensive sectors did well, so rotating from one sector to the other 3 or 4 times/year as market conditions dictated was far more profitable than just Buy and Hold. With a method like this the fund's expenses are miniscule compared with the benefits of getting out of a loser and back into a winner.

It also helped back then that there was a Bulletin Board available on the Internet where customers of the database could exchange ideas. I gained a lot of good suggestions from more experienced investors and with several hundred avid investors all using the same technology. It didn't take long to find out which trading pair was the best one to be in.

Eventually, the more experienced you become the easier it gets. In my early days I used to do a "Post Mortem" on every trade and learn from my results, what did I do right or what did I do wrong. It was a lot of work in the early days but now that I have made so much money that I don't need to be chasing the "High Flyers" and have moved into the slow lane I spend very little time managing my investments and still don't know what it feels like to have a losing year.

It blows my mind that anyone can hold an investment that is in a steep downtrend - but people do. In a market like 2008 some people became paralyzed and even stopped opening their monthly statements, instead burying their heads in the sand. People like that have no business managing their own investments. If you are in the market it's essential that you know what your holdings do every single market day. On the holdings I have that trade every day I know to the dollar what I have made or lost. Repeated losses soon get my attention.

I wholeheartedly agree that being an active investor is a lot of work and that your time would be better spent on things that are more important than money.

I'm not sure I understand, through, why the logical conclusion of not being an active manager yourself is to use index funds.

Isn't a third alternative to use a third party portfolio manager (I don't mean the fund manager of mutual funds) whose risk adjusted return (after management fees) can outperform your efforts or index fund returns?

The comment of not being able to consistently beat an index is a statistic that relates to mutual fund managers, not necessarily active portfolio managers.

In this case you get the best of both worlds: your time is freed up and you have a higher probability of achieving your investment goals.

Derrik Hubbard, CFP

"Isn't a third alternative to use a third party portfolio manager (I don't mean the fund manager of mutual funds) whose risk adjusted return (after management fees) can outperform your efforts or index fund returns?"

Because active managers, on average, cannot beat index funds once you subtract costs. Some of them will, but more of them won't. That's a mathematical certainty because of higher costs.

Since less than half of managers will beat their index, how do we pick one that will? The answer is we can't know who will do that in general. So our chances of beating the index are less than 50% when we choose an active manager, and in many cases much less than 50% because of high costs.

Investment advisors can be expensive, can be good, and can be not very good.
A word of mouth referral from someone you trust is the best way to find one.
The very best ones often want a percentage of the gains when they make money but nothing if they lose money. The percentage can be quite steep if they have a really good reputation.

The Mark Hulbert Financial Digest tracks 180 investment advisory services, some for a very long time, and may be a good place to start if that's what you are looking for. The Hulbert digest may even be available in your local reference library. Many of these advisory services put out newsletters with recommendations for do-it-yourself'ers as well as providing money management services.

i have twice established a "serious" mock portfolio and benchmarked its returns to a static pool of funds, and in both cases, over the long haul the static pool outperformed the mock portfolio within which i traded actively. too much randomness + fees + A B C. my experiences support FMF's conclusion

You cannot be a very successful active trader unless you have an extensive database of mutual funds, ETFs, and market indexes that is updated daily and adjusted for all distributions. You also need software that allows you to perform many types of technical analyses on all of the funds in a particular sector. That by necessity requires that your extensive database provides the ability to select just the funds that are in a particular sector out of the thousands available. You then also need to have a knowledge and understanding of what the various types of technical indicators are for and how they work. Lastly you need to be able to put all of this knowledge, data, and mathematical indicators together when you are trying to select funds for the particular purpose you have in mind. All of this requires a lot of experience. Finally, the only way you become a really successful active trader is when you make bad trades that you then improve your skills and knowledge by learning what you did wrong and not repeating the same mistakes again. When I was investing aggressively prior to 2007 I typically ended up holding a fund between 1 and 3 months.

Don't confuse an "Active trader" with a "Day Trader", the two are very different. An Active trader only trades when he wants to upgrade the performance of his portfolio because one or more of his holdings is lagging behind the others, or has, God forbid, started a downtrend. A Day trader generally uses stocks and not funds and is looking to take quick profits by only holding a stock for a matter of days after a positive news release.

Unless you have real hard earned money at risk in a portfolio I would think that it's hard to put in all the work required to do a real great job of investing. Investing requires the emotional feedback that you get from making or losing money to provide the motivation to keep you on your toes doing a great job. Winning or losing money on a "Mock" portfolio eliminates the emotion and would have about as much effect on me as I get when I win or lose a card game on my computer.


As Old Limey indicated, it is not a "guessing game" as much as it is evaluating historical track record.

In addition to just return, you should also review the what they have done historically in other areas such as:

1. Standard deviation or volatility
2. Maximum loss in economic downturns

If you do not believe this is possible or don't have access to these kind of managers, then index funds may be the way to go.

I don't like index funds since they expose investors to the full downside of the market since they are passively managed.

Derrik Hubbard, CFP

I couldn't agree with you more!

Even now that I am in the slow lane of investing, the very first screening that I go through is based upon "Downside Volatility". The authors of the Ulcer and Ulcer Performance indices that were students of Nobel Laureate, Professor Sharpe of Stanford University say in their book that investors don't care about Upside volatility but they care a lot about Downside volatility for good reason.

The lower the volatility of the funds that you own the greater are your chances of keeping most of your gains when they start going down. Very volatile funds give you much less time to make your decisions.I find that if I screen first for Volatility and Max Drawdown and then go down the list looking for the best APR for the period in question I find the very best fund candidates in a sector.

I have also found repeatedly that ETF funds have far greater volatility than their non-ETF counterparts which is why I don't use them.

You are absolutely correct that actively managed funds offer far better opportunities than passively managed funds. Active management means that a fund manager has to have access to a lot of recent data and research on the companies he buys whereas passive management can be performed far less expensively because you don't need to know anything at all about the company you are buying. All you have to do is to buy it if it's in the index you are trying to match. These days with all the derivatives available you probably don't even have to actually buy shares of the companies themselves which makes passive management even cheaper and easier to do. If your assignment is to match an index then you have to also buy all the big losers in the index. Does that make any sense? The great fund managers of the past like Peter Lynch of Fidelity didn't make a name for themselves by picking losers for their fund - just the opposite, they only wanted to buy winners. Their only problem was that the better their fund did the more money it attracted so eventually they either had to close the fund to new investors or see their performance drop because you can't make huge buys and sells without hurting your own positions.

Fortunately little investors with a few million dollars can operate under the radar, also with regular mutual funds when you put in your Sell order, your money is out of the fund that day but the fund manager doesn't even know it happened until after the market has closed. With ETF funds however if you make a large BUY or Sell on a thinly traded fund you will cause a large movement in the price in the opposite direction from what you want.

I'm an active investor, and I'm putting in some decent time, and have been getting very sweet returns ... in return. 20 years from now I'll know if that was temporary luck or I actually know what I'm doing. So I swear by active investing.

So do I recommend other people to actively invest? Heck no! It's way too tricky. I'll refer them to index funds (emerging markets). I tell them what I just said about the 20 years from now. If they still insist on stock tips, I'll give them with an exit price or if I know we'll be in touch.

I definitely agree with it being more work to be an active investor vs. a passive investing. However, I think it takes more mental discipline to be a passive investor.

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