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Decision Moose

Decision MooseDecision MooseDecision Moose

investment newsletter & insight

investment newsletter & insightinvestment newsletter & insight

DeMOOSTIFYING STRATEGIES

Investment Strategies: Two Flavors

Portfolio  management is predicated on two personal considerations: time horizon and risk tolerance. Together they determine your diversification strategy.  It may seem that there are more investment strategies out there than there are investors. Truth is, strategies only come in two basic flavors—active and passive. 


Active Asset Management (Market Timing)

Active strategies involve actively selecting investments in an effort to outperform some  benchmark, usually a market index. They have a short to medium term  “market-timing” focus and are typified by more frequent trading. Active  strategies are the opposite of passive diversification. They can take  many forms, including the do-it-yourself market timing methodologies  promoted on this site, as well as new smart  exchange traded funds that actively manage a particular strategy for  you. Purely active strategies are more appropriate for investors at the aggressive end of the risk spectrum.

 

Passive Asset Management (Buy & Hold )

Passive management involves trying to match a benchmark by replicating its  holdings, and hopefully, its performance. Passive portfolios have a  long-term focus, typified by buy-and-hold investing. Also known as "  Prudent Man” investing, do-it-yourself diversified passive portfolios  are comprised of several non-correlated equity and income assets. The  percent allocated to each asset class in the portfolio is determined by  the investor’s willingness and ability to accept risk. Passive investing  is best employed when the time horizon is greater than 5 to 8 years,  however. 


Which Strategy Is Best?

I’ve been a  proponent of an active market-timing strategy for over thirty  years. Index Moose was my first attempt at modeling the markets using  momentum, and it worked well for 16 years, returning close to 30% a  year. In 2009, however, the Fed began a decade of financial engineering,  government fiscal policy thereafter turned deflationary, and GDP growth  stagnated. Without a tangible business cycle, bear markets, and just  the occasional correction, the model began to have a hard time keeping  up with its benchmark. This led me to the inevitable realization that no  portfolio management strategy is perfect for every place, time, and  person— not active market timing, not passive buy-and-hold, and not any  variant of the two. 


In short, when the financial environment and/or  one’s personal circumstances change, strategic approach must change. 


That was not always  as obvious as it sounds. Back in the day, we were told to pick a  strategy—active or passive-- and stick with it for life. You didn’t  deviate, because human nature being what it is, we all tend to deviate  at just the wrong time. Moreover, before personal computers, managing a  portfolio manually could be time-consuming enough without trying to  master multiple strategies to boot. Most portfolios were managed using a  diversified buy-and-hold approach, the so-called “prudent man theory”.  Mutual funds, the primary financial instrument used, were designed for buy-and-hold, and penalized frequent trading.


Meanwhile,  strategic choices were portrayed in black and white. You had to pick sides. Books were written and verbal fistfights ensued over who was  right: gambling market-timers or prudent random-walkers. It never dawned  on anyone that both active and passive approaches might be valid,  or even a mix— at different times in different situations. 


Fast-forward a  quarter century and times have changed. Everyone has a laptop, access to  the Internet, and can trade online. The brokerage fee for buying 100  shares of stock is no longer $300, but closer to zero. Exchange traded  funds allow investors to diversify and trade that diversification  intraday. Most importantly, technology has opened up the financial world  to an explosion of new ideas and products, greatly simplifying the  portfolio management process.


Strategy is Personal

Before picking any investment strategy you need to ask yourself  (1)  Am I totally committed to managing my own money? (2) Am I capable of  managing my own money? If the answer to either question is "no", hire  someone to do it for you. (In my experience, you can cut yourself some  slack on #2 as long as the answer to #1 is a firm “yes”. When you  dedicate yourself to something fully, you’ll be amazed at how quickly  you become capable.)


If the answer to  both questions is "yes", start by realizing that over time, there is not  necessarily a 'best" investment strategy for everyone all the time. A  strategy’s success or failure depends on the financial back-drop. Just  because you find something that appears to work for you now, doesn't  mean it always will. Personal situations change, and exogenous  conditions change. Ideally, one should pay attention to both and not be  afraid to adapt.


CRITERIA                                                  Active Management                             Passive Diversification

                                                                              (Market Timing)                                           (Buy and Hold) 


Experience Required                                Moderate/High                                    Low/Moderate 

 

Maintenance Required                            Moderate                                                 Low 

 

Time Horizon                                                  Short/Medium                                     Long/Medium 

 

Taxable Account                                            High trading costs                             Low trading costs 

 

Tax-Deferred Account                               Moderate trading costs                 Minimal trading costs 

 

Account % of Total Assets                       Low/Moderate                                     Moderate/Large


Knowing yourself  and your situation, then, is as much a key to successful investing as picking the right assets. Personal and portfolio Issues will determine  your best strategy. Now that you've scored your questionnaire and have  quantified those issues-- like commitment, experience, education, type  of account, relative size/importance of account time for maintenance,  investment time horizon, etc., use the table below to gauge which  strategy provides the best fit.


What is Investment Risk?

Price volatility is a synonym for investment risk. Stock prices move up and down quicker than bond prices, for example, so equities are considered riskier than bonds. The higher the percentage of stocks in a  portfolio, the riskier the portfolio.  An aggressive portfolio is 80-20 equity to income. A growth portfolio is 60-40. A growth and income portfolio is 40-60, and an income portfolio is 20-80 (with most stocks being dividend producing.)  Maintaining the desired balance over time as prices changed used to be work. Nowadays, there are smart ETFs (exchange traded funds) that passively  manage a particular asset allocation strategy for you.


Ability & Willingness to Accept Risk Is Key

Ability and  willingness to accept risk is probably the most critical personal input  into a successful investment strategy. Now that you've scored your  questionnaire and have defined your ability and willingness to accept  risk, use the table below to gauge the best strategic fit. 


CRITERIA                                 Active Management            Passive Diversification

                                                             (Market Timing)                        (Buy and Hold) 

 

Risk Profile                              Aggressive/ Moderate                 Moderate 

 

Asset Volatility                      High/Moderate                                Moderate 

 

Portfolio Volatility               High                                                         Moderate 


Risk and gain are  directly correlated. Making more money requires taking more risk. Since  active portfolio management costs more (trading costs plus time) than  passive strategies, it requires a greater return to match the net gain  from passive strategies. Earning a greater return requires absorbing  more risk. Higher risk (active) portfolios tend to be more volatile over  time than lower risk (passive) portfolios. This isn’t due so much to  basic asset volatility, which may be the same for both strategies long  term, but due rather to the shorter time frames associated with active  management. Active portfolio changes tend to occur when asset volatility  is above average.


What Works and When

Face it: the first  thing investors look for in a strategy is performance. Some strategies  outperform in bear markets and others in bull markets. In addition,  relative strategic performance can vary as different exogenous forces  come to bear on the financial markets. 
 

Investors can get impatient, wondering “What has my strategy done for me  lately.” The answer is not solely about current performance, it is also  about what can happen at the extremes. How a strategy behaves in  secular (long term) bull and bear markets is just as relevant as what it  is doing at the moment.

   

CRITERIA                                                                 Active Management                  Passive Diversification

                                                                                            (Market Timing)                              (Buy and Hold) 

 

Bear Market: Drawdown Risk                                 Low                                                 Moderate/High 

 

Recovery Period: Gains                                               Low                                                  High

 

Bull Market: Gains                                                          Moderate/High                        Moderate/High 


Active strategies  generally carry less drawdown risk than passive strategies in bear markets. They also tend to lag passive strategies during the initial  recovery period that follows a bear market. 


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