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Posted by on Jul 17, 2014 in ETF Strategist

Success Through Stupidity Avoidance

By Roger Nusbaum AdvisorShares ETF Strategist

Tren Griffin has a terrific blog post on the active passive debate that focuses on the subject from Charlie Munger’s perspective (Griffin is working on a book about Munger).

The general tone of the post was that active management is difficult, most will fail at it (will address failure in a moment), it relies on finding assets that are truly mispriced and it requires a skill set to find truly mispriced equities that most people don’t have and proper diversification comes with far fewer holdings than many people believe.

A couple of great quotes in there include a pretty famous one by Munger where he places great importance on not being stupid. Another one was” being a successful active investor requires a massive amount of time and work. If you don’t enjoy it, why do it?” There was also this; if you are not a passive investor, you must beat the market after fees and expenses. The point being don’t bother if you’re not beating the market.

There’s a lot of ground to cover here. It’s not that I necessarily disagree with the article (a couple of points I do disagree with which we’ll get to) but the real world is much broader than the ground covered in the article.

The definition of active investing can include owning anything beyond a total stock market fund and total bond market fund. There is even an argument that rebalancing between a total stock market fund and total bond market fund is active management.

Actively managing a portfolio is difficult because of the work involved. Some amount of time needs to be spent on each holding (this varies from holding to holding and investor to investor). There is also a knowledge base required to do the work.

Finding (or more correctly looking for) mispriced securities and buying them is certainly one form of active management but there are many others. There are trading strategies that actively use broad based passive ETFs in various trend following or momentum techniques; active management with passive funds. Like any active strategy some number will beat the market and some number will lag the market. And there are countless other forms of active management that don’t solely rely on mispriced securities.

The idea of failing can mean anything but what it all boils down to for most individuals including clients of financial professionals is whether or not they have enough when they need it which is an ongoing theme here. It doesn’t do anyone much good to say they beat the market over the course of their investing career if they are 80, healthy and out of money. It is difficult to describe a long term strategy (active or passive) that results in having enough when you need it as being a failure.

As a middle ground, if we think of a passive strategy as owning broad based index funds then the result will track those indexes less what should be a pretty low expense ratio.

Generally tracking an equity index for the equity portion of the portfolio is not going to be suitable for every market participants. Two simple examples would be dividend oriented investors or investors who are not comfortable enduring the normal ups and downs of the stock market.

In round numbers, the S&P 500 yields about 2% and has for quite a while. Building a dividend oriented portfolio is a form of active management and would likely look different than the S&P 500. Arguably, the primary goal of a dividend oriented portfolio is not to beat the S&P 500 over some short or long period of time, although it might, the goal is probably to generate an income stream. In the last five years the S&P 500 is up 125%. If in that time a dividend oriented portfolio is up 100% and the income stream from dividends has also gone up 100% is the owner of that portfolio a failure?

The same would apply to a low volatility portfolio that prevents someone from panic selling after a large decline and staying on the sideline while the market goes right back up.

The idea of why do it if you don’t enjoy it is very important. Most people can manage their portfolios provided that are willing and able to put in the time and are capable of continuing to learn. How interested are you in investing and markets? Probably very interested if you’re reading this site. OK, but how interested are most of your friends? Very few of my friends are interested.

The bottom line for most people, repeated for emphasis, is having enough when they need it and most people will get there by having an adequate savings rate and, with a nod to Munger, not being consistently stupid.