Many terms are being tossed about in the effort to describe various investing methods, processes, and beliefs一 things like “active”, “passive”, “efficient markets” and an emphasis on fees and costs. This can leave an investor with the feeling of black vs white or good vs evil. There are strong advocates for each style that add to the confusion. As with most things in life, the “effective” method lies somewhere in the middle of the extreme positions.
On the passive side of the argument, the case made is that all the information there is to know about a particular security, whether it be stock or bond, is already in the marketplace, therefore this is nothing extraordinary to be exploited by active traders and market makers. In today’s world of 24-7 global news coverage, this makes a lot of sense. The moment a piece of news is known, it is shot around the world on a myriad of devices including Bloomberg terminals and computers, tablets and smartphones. The market reacts immediately and determines the “price”.
On a primary basis, the case for investing in stocks is to participate in the growth of the economy, domestic or worldwide. It also allows our hard-earned capital to grow faster than the inflation rate to assure that our purchasing power is greater when the time comes to consume it for education, retirement, or other needs. The case for passive investing includes the ability to invest in established markets at very low costs and likely experience low turnover, thereby incurring less tax costs. 10-20 years ago when information was less available on small cap stocks, international stocks, or emerging markets, an edge for active management to exploit less available data, was more present. This also has largely gone away. The global 24-7 news machine dips into markets and seeks out any piece of information, to which the market immediately reacts.
So far, intelligent and gentle reader, you likely have come to the conclusion that active management is on the path to joining the dinosaurs into extinction, and that the passive approach for core investing offers many advantages. Yet, opportunities exist for the experienced investor to exploit; they just aren’t the same opportunities of days gone by.
For established and well researched markets such as large caps (S&P 500, Russell 1000), small caps (S&P 600, Russell 2000), and International (MSCI EAFE, MSCI EM), following an index can lead to good results for those markets. Yet the investing world today offers more in the opportunity set than stocks bonds and cash, and in many ways, other opportunities have never been more available to investors.
The additional opportunity sets of alternative investments add value to a portfolio design. Intelligent investors recognize that exposure to stock/equity markets brings with it the volatility of that asset class. Stocks are volatile because investor emotions frequently drive purchase and sale decisions. Right or wrong (mostly wrong), the drives of fear and greed, inbred into our beings for thousands of years, position humans to be poor investors. They cause investors to get aggressive at the tops of markets and want to sell to qualm fears at the bottom. In previous years, bonds played a large role in controlling volatility, but at the present, historically low interest rates, the sacrifice to returns is high. There must be a better way!
In my next post I will explore opportunities in portfolio design to moderate volatility and continue to provide inflation offsetting returns while exposing areas where active management can still have a role as part of a portfolio.