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.