Last week I put up a post about active versus passive investing that included my belief that the debate is not as linear as people make it out to be. I don't believe that alpha has to be finite, I do believe people can beat the market but not all the time, there are way too many variables for this to be tied together in a tidy and congruous fashion. It is just more complicated than that.
On the Seeking Alpha version of that post a reader engaged me in an interesting discussion summing up his point by noting that for every active winner there must be an active loser and lumping them together equals the market's result. Again I do not believe it is that simple, first there is no way to lump everyone together, I mean everyone. Would you define someone who went 100% cash on January 2, 2008, an active manager or a non-participant?
I responded that I am not saying most people beat the market just that explaining this is not as simple as the academics believe. The reader responded that "even outside of academia it is impossible for the average person to be above average."
I responded again with what I thought was an interesting example that I believe shows the potential complexity of the issue or should I say the lack of congruity in explaining the issue.
First here are the results for the S&P 500 for the most recent bull market cycle and the down year of 2008 not including dividends.
2003 up 26.4%
2004 up 9.0%
2005 up 3.0%
2006 up 13.6%
2007 up 3.5%
2008 down 38.4%
If someone invested $100,000 into the S&P 500 level based on the close on December 31, 2002 they would have $102,780 or a return of 2.78% not including dividends on December 31, 2008. So now let's look someone else who had an actively managed portfolio during that time that did not do very well most of the time. Let's say that for 2003, 2004, 2005, 2006 and 2007 this person lagged the S&P 500 by 5% in each of those years meaning that in 2003 he was up 21.4%, 2004 up 4% and so on.
At the end of 2007 the first investor, the passive investor, would have had $166,851 and the lagging active manager would have had $132,356. With no other information about the second investor's circumstance the lag would have compounded into a meaningful number. Now let's say that whether by luck or skill the active investor went 100% cash on January 2nd, 2008 and missed the entire 38.4% decline. In that case the passive investor would have $102, 780 on December 31, 2008 and the active investor would have $132, 356. Again with no other information the difference is meaningful.
So is the active investor above average? Did he beat the market? I think both yes and no can be argued here. The guy lagged the market for five years in a row but came out way ahead anyway. Regardless of where you stand on active versus passive I don't think the active investor chronicled in this post is easily lumped in with the winners or the losers as framed in the reader comment mentioned above.
To repeat what I said above and last week the debate is simply not as tidy and congruous as some people believe.
Proud Member Of
Random Roger
© 2009 | Gadget Theme Blogger Template
Original WPtheme By Blogger Template | Converted By Gadget Lover
| Distributed by eFree Blogger Help
Original WPtheme By Blogger Template | Converted By Gadget Lover
| Distributed by eFree Blogger Help
9 comments:
The average person can not be above average seems reasonable enough to me. But a lot of these people spend more time reading their cereal box than analyzing how to invest their assets. So I think a rational approach by the active investor can pay off well.
Roger here is a question for you and your readers. I have 1000K that I plan to have last for 20 years. I also have 100K in a Roth IRA sitting in cash at the moment. How would one invest this 100K believing it will not be needed for at least 20 years (if ever)? I am 65 and retired.
how would one invest? prudently.
we're not handing out fish here, if you follow me.
You are correct, Aplha need not be finite. It only risks becoming finite when we let others know about it.
Mum's the word mate.
Happy New Year!
Great example Roger,
Another way to look at this is an active investor who took defensive action in 2008 and went down by 1/2. In that case using your numbers his portfolio would be worth about 107k, slightly better than the passive return, with much less volatility. Not likely he would have done something stupid at the bottom.
While pursuing a field biology degree I discovered the notion of species I had previously learned was off base. As the evolutionary biologist Ernst Mayr phrased it (back in the 1940's I was chagrined to discover): "For the typologist, the type (eidos) is real and the variation an illusion, while for the populationist the type (average) is an abstraction and only the variation is real. No two ways of looking at nature could be more different." A species is a cluster of lesser genetic variance within a field of greater variance at a given moment in time rather than an actual reproductively defined entity? Sheeit, now you tell me!
IAC approaching the markets as a populationist means you tend to view averages as measures of momentum and direction rather than a more or less stable central tendency and reversion to the mean refers to granularity (coarseness) of measurement and pattern of directionality over different time-spans rather than any fundamental property of the system.
IOW an 'above average' investor can lose more than they make over an investing lifetime, a 'below average' investor can make more than they lose, and vice versa for both; it depends on what, when and where analysis occurs. The notion of "zero sum" only makes sense in regards to individual interactions at specific moments in time; it is the real, risk-adjusted ROI of all such interactions that translates as wealth over a lifespan.
Let's hear a cheer for the tortoise!
I went to a corporate meeting held by Vanguard about our 401K's. They are still espousing buy and hold index funds, with a disregard to yield curves, inflation, and even your investment horizon. They did not present the past five or seven year return on the S&P 500, just the year to date. See how good index funds are?(ahem, to steal Rogers line).
I agree with 6:51AM. Most folks spend little or no time on their retirement planning, and simply follow the spin they hear the most. Look at the mean age of part time folks at the big box stores. It tells how many retirements are properly funded.
Roger, one of the lessons I've learned at this blog is sometimes doing nothing is the right thing to do, and taking some money off the table reduces an emotional reaction to a normal down event. Thanks for the blog.
Sam
thank you Sam
In terms of judging the performance of the active manager, the outcome is mostly of little interest - precisely because of the skill vs luck question. However, if the manager was taking on very large relative risk, and were explicit about it before and during the underperformance cycle, and clients bought into it and stayed the course (the hardest thing to do), then you are most likely to conclude they have skill. Think GMO in the late 1990s and early part of this decade.
The key here is for he investor to define their objectives well, and then to invest their money with managers that understand and share those objectives (e.g. absolute vs relative returns).
This sort of thing crops up all over the place - for example, in comparing public versus private markets. If a PE manager returns -5% versus the S&P returning -10% over a long time period then I personally would be very disappointed. If the numbers were 15% and 20% rewspectively then I'd still be disappointed, but the high absolute returns would cushion the tears a little bit.
Post a Comment