Active investing seeks to outperform the market. Active investment managers try to identify companies that offer above average returns. Whether they focus on companies with impressive growth in sales and profits, promising new products, or a turnaround story, all active managers share a common belief that markets are inefficient and they can deliver better returns than the indexes.
Active managers rely on company meetings, news and announcements, detailed analyses, unpublished research, and the insights of highly paid investment professionals. The active manager overweights certain stocks and underweights others, or perhaps does not buy them in the first place. They choose from hundreds if not thousands of different investment strategies in attempts to outperform their benchmarks.
Most financial advisors rely on active management investment advice to guide their clients. They justify their high fees with promises to outperform the markets with a winning strategy. Common sense and a vast body of research tell us this simply is not possible.
Track Record Investing
Track record investors rely on historical data to predict future success. Based on a track record, they may place their faith in a fund, an adviser, a private investment newsletter, or Morningstar ratings. When active fund managers point to charts and graphs that demonstrate the market-beating performance of specific funds, they implicitly suggest that track records work. Most investors fail to recognize that these charts have nothing at all to say about how a fund will perform next week, much less next year. What the charts do demonstrate is how certain asset classes performed in the past. Passive investors would have reaped the same gains at much lower expense. The same holds true for track records of active investment advisors. The best can only be identified after the fact, and only then when performance can be shown to be related to skill and not random luck.
Even when a fund manager does have a record of out-performance, it can change overnight. An adviser’s track record may be related to a particular skill or investment style or, more likely, to fortuitous asset class selection. This point was born out by a 1992 study of the Forbes Honor Roll. John Boggle examined the performance of 15 to 30 mutual funds annually named to the Honor Roll between 1974 and 1990. He found that subsequent to being selected, these funds tied the performance of the average stock fund, and significantly underperformed the market after accounting for all costs. Luck, not skill, is what lands funds on honor rolls.
Despite the obvious flaws in track record investing, millions of investors rely on Morningstar track record ratings to guide fund selection. Funds that perform well receive five stars; those that do poorly get one star. Because funds are a reflection of their stock holdings and asset classes, a sector that falls out of favor can knock a fund from five stars to one very quickly. The average five-star rating only stays in place for about eight months. Investors face a dilemma: chase the rating, or stick with the fund that has been downgraded. Ultimately, a five-star rating is simply a way of saying “this fund has performed well in the past.” It is not a predictor of the future.
Market timers move money in and out of the market in attempt to profit from short-term events or sit out downturns. Some use historical trends and data to time their moves, while others rely on advisors or their own hunches. For market timers to make money, their timing must be impeccable. Getting it wrong, even just a little bit, has a huge impact.
It’s particularly important that market timers get into a rising market at the beginning, when the gains are richest. Missing the best 25 trading days between January 1970 and December 2009 would have cut S&P 500 returns from 9.87% to 6.01%. Stated another way, missing the best 25 days out of more than 10,000 trading days over 39 years would have cut gains by 39%. One would have to be a phenomenal timer to get it right.
The problem is that the best days to be in the market often follow disastrous stock sell-offs, precisely when market timers are most likely to be on the sidelines. Twelve of the 25 best trading days of the same 39-year period mentioned above occurred between September 2008 and March 2009, a period in which the S&P 500 fell 37.7%. By retreating during down times, market-timers risk missing swift market rebounds.
For the average investor, market timing is a terrible strategy. It takes nerves of steel to buy into a market that seems to have no bottom. But market timers must act when pessimism is greatest—something they can only sense but never truly know. Likewise, when markets begin to climb, market timers must decide when to get back in. Swift upturns can just as easily revert to steep setbacks, and the wrong entry point can be disastrous.
Passive investors reject market-timing strategies in favor of a buy-and-hold strategy that keeps money invested during good times and bad. Over more than a century of measurable financial history, the markets have rewarded investors with long-term gains in value, despite wars, economic, social and political turmoil, and natural disasters. The passive investor establishes risk parameters through diversification, and then lets the market do its work.