Monday, August 31, 2009

One Feather in the Active Investor's Cap..

During the plane ride back from SFO to Manchester, I read Allan Roth's book "How a Second Grader Beats Wall Street," which uses a gimmicky sort of backdrop (Roth's lessons in finance to his second-grader, who possesses a mind uncluttered by most modern marketing pitches to adults) to explain why passive investing is far superior to active investing -- seven days a week, and twice on Sunday.

Roth's basic premise is hard to beat -- by saving the money you'd spend on the management fees, the taxes generated by frequent transactions, and the initial loads charged by mutual funds, and by investing instead with broad-based index funds, you'd earn far superior returns in the long-term. And that's without even factoring in the sub-par performance of many actively-managed funds.

Roth uses tons of charts and mini-spreadsheets to prove his points, and I'd say he does so pretty conclusively. He frequently references an Einstein quote -- "If you can't explain something simply, you don't understand it well enough," and earns the right to use it with his down-to-earth explanations.

Throwing a bit of psychology into the text, and several well-deserved nods to Burton Malkiel and Jack Bogle, Roth cites the Lake Woebegone bias of almost everyone who has ever held an equity -- the fallacy that the pitfalls faced by the *average* investor obviously don't apply to him or her, who is clearly above average. Of course, mountains of data show that trading frequency is negatively correlated to yields, in part due to transaction costs and taxes, but perhaps more due to individual investors' equal-parts-steadfast-and-irrational belief in their uncanny ability to time the market.

Roth also made me laugh out loud on the plane when he talked about how everyone he knows comes back from Vegas claiming to have won money. For me, substitute 'Foxwoods' or 'Mohegan' in there and you have a blog entry I've been meaning to write for some time -- the incredible effect of mental accounting that really means people aren't actually *lying* when they talk about how they're "up" in their lifetime of casino gambling...they really mean it!

Anyway, I don't doubt for a minute the accuracy or the soundness behind an Allan Roth or a Burton Malkiel. I do, however, want to chime in with one argument in favor of active investing that I haven't come across from either of them (or from Jim Cramer, for that matter) -- the personal education that comes from active investing in publicly-traded companies.

Let me explain.

Think back to when you were a kid. You learned about fairly complex and arcane rules in sports, like what can happen on dropped third strikes, or what happened when a shooter was fouled from beyond the three-point arc, or when the whistle blows for icing, not by burying your nose in a text, but by actively following something with a rooting interest. Some of the information just sort of rubbed off on you, but other parts of it worked into what made sense because they happened in a context you understood and cared about.

Something similar and even greater might apply with investing.

To take a balanced approach, let's say you're indexing with half your portfolio, but you're taking the other half of your portfolio and you're actively playing the market with individual equities.

While your index fund boringly works away for you (over the LONG-term that is, you'd have to have the intestinal fortitude to make it through years like 2008 and not panic), let's say you've got 10 other plays, spread out across sectors like energy, consumer staples, big pharma, entertainment, defense, automobiles, and the financial sector.

All of a sudden, you've got a personal stake in all these things. You've got a rooting interest that's much more vested than the one you'd have in something extremely broad-based like the Russell 5000 or even just the S & P 500. By following these companies' ups and downs, the shake-ups to their managerial staffs, and the ways things like developmental drug patents or looming defense contracts might affect share values, you're learning about business, which is what really makes this country run.

I would even say that if you took a legendary investor like a Warren Buffett or a Charlie Munger, they'd probably be one of the most interesting dinner party guests out there -- not because they could regale you with stories about yachts or wintering in St. Tropez (they wouldn't, anyway) but because these are truly our modern Renaissance Men -- their career-long scrutiny of countless annual reports, prospectuses, and business summaries has brought them so much intimate familiarity with so many sectors of the economy, not to mention the way the captains of industry intersect with political leadership, that they could probably speak intelligently on just about any topic that could reasonably come up. Even amazingly impressive experts within single fields of study probably couldn't do it as well.

Remember that old joke about how the New York Times is read by people who think they run the world, but the Wall Street Journal is read by those who actually do? There's probably a little bit of truth to it (though not to any follow-up jokes about USA Today readers being illiterate -- those are all unfair and untrue).

I don't for a minute doubt all the wisdom and hard math that go into what people like Malkiel, Roth, and Bogle have developed in their studies. Nor do I think I'm about to fall into the trap of the self-styled 'exceptional investor,' which is almost as dangerous as the 'exceptional roulette player.'

But I think that allocating a portion of your portfolio to stocks that you actively choose and then track is a lot more fun than indexing alone. And as that personal stake draws you away from your usual TV fare to a little more CNBC, and from your usual political blabber news sources to more exposure to things like Forbes, Fortune, and the Wall Street Journal, you're coming away from the experience a bit better-rounded.

And that alone is a good thing, and that alone has value.

5 comments:

kad barma said...

Buy on the dips, and hold, baby!

C R Krieger said...

I heard that San Francisco was cold and foggy.

The New Englander said...

Kad,

Great advice, but the sad thing is how many people do exactly the opposite...it was in Random Walk that I first read how things like 401(k) and IRA plans get the most dollar infusion at the HIGHEST peaks in the stock market, and how people are most likely to pull money out at the bottom. Seems crazy, but there was that Lowell Sun headline last week about how 401(k) contributions were just starting to increase now that the market had made such strides since March.

Another example of how doing leads to knowing is the financial stuff surrounding homeownership. I think that seeing firsthand how a refi might not always be good, or learning what equity is (many think it's the percent of the loan paid off, but it's not -- it's based on assessed value and outstanding loan amount)...it's an expensive way to learn sometimes but I find that friends who don't own their own homes are unfamiliar with a lot of this..

And Cliff, I would say you have outstanding HUMINT from a reliable source with direct, first-hand access to the information. Cold and foggy only on the first and last days only, though, as the unexpected sunburn I got on days 2 and 3 stands as proof..

best,
gp

Ari said...

The only thing I'd add Greg, is that while I agree that indexing is better for the average investor, it is quite clear at least in my mind over the past year how much gaming is done to the system, and so there are definitely people who are exceptional investors, not because they are exception in any real sense (though some are, a la Buffet) but because many of them are gaming the system (legally or illegally). It's an important thing to bear in mind as you're protecting (and diversifying) your assets and learning the markets, I think

The New Englander said...

Ari,

Yup, gaming has GOT to be at work with certain stocks, esp. the extremely volatile ones. Take, for example, Fannie Mae (FNM) and Freddie Mac (FRE) over the past month. They've had day after day of wild swings in the double-digit percentages. There's just no fundamental or technical analysis that should support that...it seems way more likely that folks with deep pockets (or access to others' deep pockets) are riding it up, dumping it, doing it all over again, and laughing all the way to the bank..

best,
gp