Active Investing is Masochistic

Years ago I came across a book by Jim O’Shaughnessy called, “What Works on Wall Street”. Since then, the book has become an investment classic and continues to be a great source of information. Jim also has a fantastic blog which I consider a must read for any investment pro.

Jim’s latest post was a timely reminder that even the best strategies and managers go through extended periods of under-performance. In my last two posts I talked about how small cap investing is currently struggling, an unusual experience in the context of a hundred years of data. It’s also unusual in my lifetime of investing. I can’t remember a time when I have had such difficulty finding and trading successful trends in small stocks. For the past 2 years, almost every breakout has either fizzled, or shot straight up for a couple months before tanking violently with no warning.

Now, Jim’s advice in this sort of scenario is to stick it out no matter what. He cites several similar historical cases in which great strategies or great fund managers were down on their luck but refused to cave to pressure and stuck to their approach:

  1. Warren Buffett, whose performance from 1996-1999 lagged the markets by 7.6% per year. Buffett had the last laugh when the tech bubble burst.
  2. John Neff, who was ridiculed for sticking to value investing in the early 1990s, and then went on to trounce the markets in subsequent years.
  3. Reese and Forehand’s methodology, which lost 23% in 2014 and 20.4% in 2015 (when the market was up 11.4% and -0.7% respectively), but has great long term returns and bounced back in 2016.

Jim’s essential point is that it is virtually impossible for ordinary humans to stick to sound investments strategies when they have a rough patch. He has this great quote from Calvin Coolidge:

“Nothing in this world can take the place of persistence. Talent will not: nothing is more common than unsuccessful men with great talent. Genius will not: unrewarded genius is almost a proverb. Education will not: the world is full of educated derelicts. Persistence and determination alone are omnipotent.”

Now, I agree with Jim that active managers must stick to their knitting, no matter what, if they want to have any hope of beating the markets over the long term. I also agree with two points he makes near the end of his post:

  1. Passive investing is behind the recent poor performance of many managers
  2. Over time, it is possible to do better than passive indexing

However, I tend to believe that the rush to indexing has a great deal further to go. As I’ve said previously, there is a vast pool of money in superannuation here in Australia, or in various pension funds in the US, that is now moving out of bonds and into stocks. This money has, and mostly will continue to, move blindly into the largest stocks in the market regardless of their merits. This is providing a strong tailwind to large stocks, but it is also sucking money away from better investment opportunities that can be found in smaller stocks.

As a trend following investor, I’ve long believed in following the crowd when it charges in one direction like a herd of lemmings – and then I try to get out while the others go off the cliff. While I agree with Jim that the profitability of picking good stocks will return at some point in the future, when everyone is in passive, for now I suspect the prudent course is to have a foot in both camps – both large caps and small caps. My systems are easy to adapt to large cap investing after all, and that seems to be where the dumb money is going these days. I can’t imagine a scenario where I would every give up on small cap investing. It has simply been too good to me over the years and I will always tilt the portfolio towards smalls. But I have no problem with diversifying my investing when all evidence tells me that the market currently favours large stocks.

UPDATE

Ben Carson’s has some sage advice relevant to the above discussion:

Avoid extreme all-in or all-out stances … Holding 100% of your portfolio in any single asset class is mentally draining. Investing doesn’t have to be black or white. Allow yourself room to be breathe and a margin of safety if you’re wrong.

Minimize your regret. I like to say that investing is inherently a form of regret minimization, a process that’s full of trade-offs. Long-term returns are the only ones that really matter but you have to figure out how to survive the bad times enough to ensure a good process can see you through to make it to the long-term. A balanced portfolio approach won’t always put you in a comfortable position but it’s a great way to avoid blowing up your portfolio. There’s a lot to be said for giving up on the dream of hitting home runs to avoid striking out and instead, accepting singles and doubles.

I interpret Ben’s advice as follows: it’s ok to blend my strategies with other styles. Mixing in large caps and Index etfs is a great way to ensure you don’t miss out on a rally simply because small caps are suffering a temporary correction.

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