questions any investor should ask. If your answer is no, if you believe the market
is efficient, then passive investing or indexing—buying diversified portfolios
of all the securities in an asset class—is probably the way to go. The arguments
for such an approach include reduced costs, tax efficiency, and the fact that, historically,
passive funds have outperformed the majority of active funds .
But if your answer is yes, it is possible to beat the market, then you should
pursue active portfolio management. Among the arguments for this approach are
the possibility that a variety of anomalies in securities markets can be exploited
to outperform passive investments ; the likelihood that some companies can be
pressured by investors to improve their performance; and the fact that many investors
and managers have outperformed passive investing for long periods of time.
But the active investor must still face the challenge of outperforming a passive
strategy. Essentially, there are two sets of decisions. The first is asset allocation,
where you carve up your portfolio into different proportions of equities,
bonds, and other instruments.
These decisions, often referred to as market timing as investors try to reallocate
between equities and bonds in response to their expectations
of better relative returns in the two markets, tend to require macroforecasts of
broad-based market movements.
Then there is security selection—picking particular stocks or bonds.
These decisions require microforecasts of individual securities underpriced by the
market and hence offering the opportunity for better-than-average returns.
Active investing involves being overweight in securities and sectors that you
believe to be undervalued and underweight in assets you believe to be overvalued.
Buying a stock, for example, is effectively an active investment that can be measured
against the performance of the overall market.
Compared with passive investing in a stock index, buying an
individual stock combines an asset allocation to stocks and an active investment
in that stock in the belief that it will outperform the stock index.
In both market timing and security selection decisions, investors may use
either technical or fundamental analysis (see “Technical Analysis,” “Value Investing,”
and “Growth Investing”). And you can be right in your asset allocation
and wrong in your active security selection and vice versa. It is still possible that
an investor who makes a mistake in asset allocation, perhaps by being light in equities
in a bull market, can still do well by picking a few great stocks.
There are arguments for both active and passive investing although probably
a larger percentage of institutional investors invest passively than do individual
investors. Of course, the active versus passive decision does not have to be
a strictly either/or choice. One common investment strategy is to invest passively
in markets you consider to be efficient and actively in markets you consider less
efficient. Investors can also combine the two by investing part of a portfolio passively
and another part actively.
Active Portfolio Management Guru: William Miller
It is hard to be the best performing manager for the past five years out of a field
of thousands. Not just that it is so difficult to be there—and it is—but also difficult
to maintain one’s mental balance. The temptation is to be too cocky and believe
the publicity one receives. Or one could become too concerned with the
inevitable stumble that lies ahead: Old Bill has just lost it, some will say.
One way Bill Miller of Legg Mason’s Value Trust keeps his head is to stress
the intellectual side of investment. And he concentrates his investment attention
so that extraneous contemporary PR does not distract him. His job is to outperform
and every instinct he has is brought to bear on that objective. Over and
over, he can repeat his lessons from profits and losses. His shareholders’ glories
and pains are his own. He takes the lessons, structures them into principles, and
keeps improving.
Miller is rather liberal in defining the details of his tactics when it suits
him. He is not bothered by people who say that Czech bonds, for example, or
go-go technology stocks trading at sky-high price-to-earnings ratios are not value
investments: if they go up, they were, and that is what counts. The definitional
straitjackets of others are their problems, not his.
Miller is reaching out to complexity and the Santa Fe Institute, where he
is a trustee and has a house, to teach him how to break today’s investment
bronco. Few others have the patience to deal with the ambiguities inherent in
any emerging science. And it lets him contemplate the future of investment
styles with a catholic perspective, a dogged determination to triumph, and in the
company of physicists ready to humble anyone wasting a good mind on one of
the soft sciences, for money.
Read More : Active Portfolio Management
