Wednesday, January 4, 2012

Hail Mary Argument for Active Investing

Canadian Couch Potato recently posted a thoughtful criticism of Gordon Pape’s argument in favour of active investing. Pape’s reasoning strikes me as another example of what I call the ‘Hail Mary’ argument.

Passive index investors receive market returns less modest costs. Active investors also receive market returns, but their costs are much higher. So, on average, active investors get lower returns than passive investors. This is true whether market returns are high or low.

Despite this argument, which is based on simple math, we often hear people say that when the markets give poor returns, you have to become a stock picker to get decent returns. On the surface this is true. The only way to beat the market is with some active investing approach; passive investors will never beat the market.

However, the average active investor will still lose to the market. A few will beat the market, and most will get less than market returns, even when market returns are poor. For most investors, trying to beat the market is a Hail Mary approach. It probably won’t work, but passive investing is guaranteed to not beat the market.

So, what’s wrong with a Hail Mary? Football teams try them all the time. They’re exciting and occasionally they work. Unfortunately, there is a big difference between football and life. Football teams only try a Hail Mary when it’s the last hope before all is lost. There is no difference between losing with a conservative play and losing with a failed Hail Mary. But, in real life, there is an important difference between getting a cumulative passive return over a decade of 25% and getting an active return of 0%.

The only way it makes sense to use active investing is when there is a reasonable expectation of outperforming passive investing. The investor has to be correct in his belief that he is so much better than other active investors that he will overcome higher investing costs to beat the market. Just hoping to outperform by luck is little better than gambling at the roulette table.

6 comments:

  1. Agree with all you say.

    If investing in stocks, then out-performance depends on the ability to be a good stock picker. That is rare.

    However, when investing with options (I am not referring to doing something stupid, such as buying options), the trader can increase the probability of earning a profit.

    Yes, profits are limited, but if beating the market is your goal, conservative option strategies offer a better path.

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  2. Thanks for the mention, Mike, and nice analogy. It has always seemed odd that people instinctively believe that active management is more likely to deliver outperformance when market returns are low. As you point out, the same math applies whether the markets are flat or they return 20%.

    Happy new year.

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  3. @Mark: It's certainly possible to cap downside risk with options. And you can get achieve a good probability of outperforming the index (in a given year) by investing in an index and writing covered calls. However, over the long term, these things are likely to reduce returns. I'm still struggling with determining which situations (if any) it would make sense for me to use options.

    @Dan: Some seem to think that active management will outperform when the market is down, and others just think they have to try something to get decent returns when the market is down. Neither of these make sense to me.

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  4. If an active investing approach is like throwing a hail mary, is a passive investing approach like running the ball three straight times for nine yards and then punting? :)

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  5. Active investing (not to mention speculation), makes sense when you are NOT the average investor. It's pretty obvious you're not going to achieve above-average results in a zero sum game by being unskilled. But not everyone is unskilled.

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  6. @Echo: That's funny. I was actually referring to a particular type of justification of active investing as a Hail Mary. It's "stocks are performing poorly so I have to try picking better stocks even though I don't know what I'm doing" justification.

    @W-at-ORF: I think you need to be more precise (and in doing so the meaning changes). Active investing makes sense when you are significantly more skilled than the dollar-weighted average active investor.

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