Yearly Archives: 2014

Do You Have MLA?

I don’t know about you, but whenever I learn about a new disease or personality disorder, I’m immediately convinced that I have some of the symptoms.  Taking a psychology class in college nearly did me in – during the course, I felt sure that I was paranoid, schizoid, and maybe even a bit crinoid!  I don’t think I’m a hypochondriac, but I might be.  Luckily for me, these fears that I may be abnormal or may be coming down with the latest bug last only for a brief moment.  When the Ebola virus hit our shores, I did check myself for fever and other flu-like symptoms, but all seems well so far…

Then I read about a truly horrifying malady that affects more Americans than any exotic virus ever will – Myopic Loss Aversion (MLA).  Over the last few decades psychologists have been identifying behavioral biases that cause us humans to make irrational choices.  Newer studies have applied some of this work to how we use our brains when we invest.  Despite how rational we may think we are in times of market calm, we generally become less rational in the face of declining stock prices.

The relatively new science of behavioral economics has revealed that the pain people feel from a financial loss (even a paper one in the case of a falling stock price) is about twice as strong as the pleasure felt from a similar financial gain.  In practical terms, this means that many people are willing to give up more potential upside in order to avoid losses.  This preference of avoiding losses versus making gains seems to be hard wired into us.

Our good friends at Fidelity Investments brought our attention to a more damaging strain of loss aversion – MLA.  This form of loss aversion can affect investors who frequently evaluate their portfolio’s performance.  The more one looks at portfolio performance, the more likely one is to see a loss.  Because this causes more anxiety than the gains provide joy, the investor may want to “do something” in response to the loss.  In most cases, this means selling the losing asset class.  We saw this in full bloom during the 2008-2009 period.  We saw a smaller version of this during the week ending October 24th, where $7 billion fled the equity market in response to the recent correction.

In the extreme, MLA can lead a person to have a lower exposure to the equity market than they should, given their age, wealth, etc.  The chart below shows this.

This graphic shows that investors in this study who made decisions on a monthly basis had far less stock exposure than those who gazed at their portfolio statements once a year.  This suggests that some portion of the investing public has a lower allocation to stocks (and hence lower long-term returns) simply because they frequently look at their portfolios!

As shocking as this sounds, we see evidence of this behavior often in real life. Consider October’s stock market correction.  As the market was falling, commentators were struggling to explain the cause of the move. Even Ebola was listed as a possible reason.  How likely was anyone who sold in the heat of the moment as prices were falling able to reinvest their cash on the way up?  More likely is that people who sold are still in cash waiting for the market to go back down.  We know people who did this in 2008 and are still holding cash waiting for the market to go down…

Now imagine the person who was on a month-long cruise without access to their portfolio.  The S&P 500 closed on September 30th at 1,972.29.  Today it closed at 2,018.  The person returning from the cruise would no doubt be pleased for the market’s 2.3% gain for the month and the positive impact for that person’s portfolio.  Who would you rather be – the person who fretted and felt compelled to do something as the market corrected, or the person on the cruise?

If you think you might be prone to contract MLA, don’t see your doctor.  Simply look less frequently at your portfolio.  Your long-term returns may thank you…


To Err is Human?

The Wall Street Journal did it again.  This weekend, Morgan Housel wrote an article bashing the individual investor.  His motivation in penning “The Three Mistakes Investors Make Over and Over Again” was no doubt to help individual investors from making these mistakes over and over again.  Yet at its heart, this article, and myriads just like it, do little to educate the investor (if they did, would we really be told how to avoid the mistakes we make over and over?), and probably just hurt people’s feelings.  In the name of full disclosure, I am equally guilty of trying to “educate” people about the capital markets.  I too probably tick off as many people as I help with my writings.  Still, there seems to be some underlying truth to the notion that we as humans are hard-wired in such a way that prevents us from naturally succeeding as investors on our own.

Let’s take a quick look at Mr. Housel’s three mistakes and please allow me to offer my perspective on them.

#1 – Incorrectly predicting your future emotions.  He writes “Too many investors are confident they will be greedy when others are fearful.  None assume they will be the fearful ones, even though somebody has to be, by definition.”  The stock market action in 2008 and early 2009 tested everyone’s resolve to be greedy when others were fearful.  All one has to do is recall the dominant feeling of those dark days – were you rubbing your hands together like McScrooge surveying a new pile of gold or were you worrying about losing all of your wealth?  I must say that I met very few people during that time who were not fearful.  When the market goes down, especially when it goes down a lot, it is NORMAL to feel fear.  Some may argue that selling when you are fearful is a NORMAL thing to do (lots of people did it back then), but I would argue that it is the worst thing you can do when you are fearful. Now that the climax of fear is well in the past, I am on the lookout for an abundance of greed.  The American Association of Individual Investors (AAII) sentiment survey is perhaps the best individual investment survey out there and suggests now that investor sentiment is somewhere in the middle – not too bearish (like in early 2009) and not too bullish (like in 1999).

#2 – Failing to realize how common volatility is.  He writes, “If you don’t understand how normal [there’s that word again – ed.] big market moves really are, you are more likely to think that a pullback is something unusual that requires attention and action.  It often doesn’t.”  I would add that most people don’t understand what volatility means. The mathematical definition deals with distribution of stock price fluctuation over time.  The great Howard Marks in a recent essay perfectly defined volatility – “… the possibility of permanent loss.”  People don’t fear stock volatility when prices are rising. They even might be able to hang in there during a mild and short correction.  What they truly fear is permanent loss.  I spoke to many rational people back in the 2008 and 2009 who truly believed that the stock market (or at least their portfolios) would go to ZERO, that they would lose ALL OF THEIR MONEY. Why would otherwise intelligent, well-adjusted and mature people feel this way?   Because they are NORMAL!  Owning a stock is unlike owning anything else.  Even if you can fully appreciate that a stock represents ownership in a real company (something that still feels very theoretical), you can’t hold it, you can’t see it, you can’t stick it in your basement with your doomsday supplies…  To most of us, it’s a bit ethereal – a number on a page, a ticker symbol on a website, a name without a face…  Yet, stocks are real, and have rewarded investors with the highest average return of any asset class over the years.  But their price volatility is common.

#3 – Trying to forecast what stocks will do next. He writes, “No matter how bad forecasts are, investors come back for more.”  He quotes Alan Greenspan, “We really can’t forecast all that well, and yet we pretend that we can.  But we really can’t.”  He quotes a 2005 study from Dresdner Kleinwort that looked at an aggregate of professional forecasts, “Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.”  He goes on to suggest that a world without accurate forecasts need not be a scary place.  The legendary investor Benjamin Graham spoke often about the “margin of safety,” something that will help the investor weather the rough spots in the market.  He suggested that having a margin of safety in one’s investments would render “… unnecessary an accurate estimate of the future.”  Long-time readers of this blog will know that I am not a fan of forecasts.  I spend most of my time trying to measure value and discover undervalued stocks.  This is what Benjamin Graham did.  It’s what all value investors do.  It is not a NORMAL way to look at the world.  It requires a personality with a contrarian bent.  In my research, I am aware of what the Wall Street experts are saying and forecasting, but rarely do I let their opinions influence mine.  I say this not out of arrogance and with any sense of superiority, but simply due to the reality that so much of what I hear and see out there is of no use or consequence to how I approach the investment decision making process.

Mr. Housel ends his piece with a hopeful homily, “You have no control over what the market will do next. You have complete control over how you react to whatever it does.”  I suggest that he’s totally correct, unless you are NORMAL, in which case you are likely to 1) incorrectly predict your future emotions, 2) fail to realize how common volatility is and 3) try to forecast what stocks will do next…

My advice to NORMAL people is to find someone less NORMAL than you (like a value investor) to construct a portfolio that will serve you well in good times as well as bad, and will help you reach your long-term financial goals.  In other words, don’t try this at home – it’s a lot harder than it looks…

Price is Not Value

During one of our recent Investment Policy Committee meetings someone uttered the simple phrase, “Price is not value.”  For professional investors, this comment may seem obvious and even self-evident.  Later, as I pondered a bit on these four simple words, I realized that most people might struggle with this notion. Let me explain.

In the everyday life of the typical consumer, price EQUALS value.  Whenever one buys gasoline, the price one pays represents the value of that gas.  Sure, looking around for the cheapest gas in the area may provide some value for the consumer, but in most consumer transactions “price = value” is probably the correct formula.  If something appears too expensive, the consumer may conclude that the product does not offer sufficient perceived value for the price.  If on the other hand, something is selling well below the norm, the consumer may question the quality of the item.  This is probably as close as the consumer ever gets to understanding the price/value concept.  We tend to feel more comfortable when we perceive the value of something being close to its price.

Applying this idea the stock market, we find that value is much more important than price.  The price of a stock is tangible, certain (at any point in time) and simple.  We can easily see the price of a stock and can chart the history of any stock far into the past.  The value of a stock, which is ultimately more important than its price, is harder to see.  First, there are many ways to measure the value of a stock.  This fact alone may confuse the casual observer who may desire one and only one definite way to measure value (we sure crave simplicity, don’t we?).  Second, stock valuations can change quite dramatically over time.  Why would a stock trading at a price/earnings (P/E – one of the most popular ways to measure value) ratio of 15 times (15x) one day trade at 12x the next? To many this notion of value seems too complex and so they tend to focus solely on price.

Value investing is based on the fact that a stock can, at times, trade at a valuation well below its intrinsic or fair value.  Value investors make money by identifying, analyzing and buying this kind of “cheap” stock, with the expectation that the stock will eventually trade at its fair value. Then they sell it. This works well for individual stocks, but what about the market overall?

It’s easy to calculate the P/E of the market by simply adding up all the earnings of the companies in any given index.  The chart below shows the P/E trend of the S&P 500 over the last 50 years.

This chart clearly shows that although the S&P 500 is now near its all-time high price, its value is in line with the 50-year average.  It also shows how expensive (by value) the market was in 1999 and how cheap it was in 2009. I think it also indicates that value by itself does not give one enough information to trade the market.  Imagine someone in 1995 concluding that because the market’s valuation was above the average, they should sell – thus missing the last 5 years of the great tech rally.  It also helps explain why those voices telling you sell now just because the market is at an all-time high are missing the point.


In my experience, valuation by itself is never enough to move the market one way or another. When stocks are expensive, the surprises tend to be negative ones.  When stocks are cheap, the surprises tend to be positive.  When the market is fairly valued, stock selection becomes more important.  Stock pickers should love where we are in the market now.


Personally, I am still able to find good value in many stocks in many sectors, giving me confidence that the bull market is more likely to continue than not.


Is There Ever One Key to Anything?

I’ll admit it – I’m a Dilbert junkie.  During my career I have worked in large companies which often displayed some of the behaviors Scott Adams skewers in his comics.  In addition to his quick wit and perceptive eye, his pointed (and somewhat twisted) humor keeps me coming back for more.

Whenever I hear “_______ is the key to _______” I immediately think of the above comic.  We all have used this phrase.  You hear it in locker rooms, board rooms, class rooms and everywhere in the media. There is something about us that craves the simple answer, and what could be more simple than the key to something important being just one other thing?

David Freedman adroitly covered this human inclination in his book Wrong: Why Experts Keep Failing Us – and How to Know When Not to Trust Them.  He posits that the more complicated the system at hand (weather, human biology, the stock market, etc.) the greater the desire for a simple answer.  “The key to weight loss is eating grapefruit” is the sort of phrase that would be soothing to a person trying to lose weight. However, the likelihood that one, simple key to weight loss exists is extremely remote.  If one did exist, would anyone be overweight?

Turning to the capital markets, we hear this kind of statement on a daily basis.  In the last few weeks I’ve heard intelligent people say/write the following:

1)   The key to the stock market is Fed policy.

2)   The market is only up because of easy money.

3)   Gold is sending a strong signal about the future direction of stocks.

4)   Because the Dow Jones Industrial Average hit 17,000, the market is poised for a correction or crash.

5)   The slowing Chinese economy will hurt U.S. stocks.

6)   The market is always strong in a year with mid-term elections.

7)   Russia’s actions in the Ukraine will surely bring down the markets.

8)   Higher interest rates will hurt the stock market.

9)   Stocks are overvalued, so they will go down.

10)There has not been a correction for 2 years, so we’re due.

I’m sure that the reader could recall other similar comments.  At their heart, all of these statements contain the idea of “The key to the stock market is ______.” I’m not suggesting that these factors are not important, but rather that any one factor by itself almost never is the reason for the market’s movement.  It’s too dynamic and complex to be driven by just one thing. This is one reason market timing (buying and selling “the market” to make money) is so difficult.  Imagine all the resources a professional investor has at his or her disposal in the attempt to time or beat the market.  Compare that to some “insight” you might have picked up by watching television or reading a newspaper.  Is it logical to assume that this one notion really holds the key to the future of the stock market?

I think not.

Exactly because “the market” is so complex, I spend very little of my research effort on it.  I focus on individual companies and their valuations.  Valuation is not the key to success to investing, but it is one important component of the investment formula.  Also, I can add much more value to the process by looking for undervalued stocks rather than trying to time the market.

So far, this approach has been working for me.






Looking for an Edge Using Occam’s Razor

Sherlock Holmes and his sidekick Watson go on a camping trip. After sharing a few glasses of chardonnay, they retire for the night.

At about 3 AM, Holmes nudges Watson and says, “Watson, look up into the sky and tell me what you see?”

Watson said, “I see millions of stars.”

Holmes asks, “And, what does that tell you?”

Watson replies, “Astronomically, it tells me there are millions of galaxies and potentially billions of planets. Astrologically, it tells me that Saturn is in Leo. Theologically, it tells me that whatever made all of this is beyond human comprehension. Horologically, it tells me that it’s about 3 AM. Meteorologically, it tells me that we will have a beautiful day tomorrow. What does it tell you, Holmes?”

Holmes retorts, “Watson you idiot, someone stole our tent.” *

This story is a classic example of the principle of Occam’s Razor.  In its simplest form, Occam’s Razor states that when faced with two opposing explanations for the same set of evidence, our minds will naturally prefer the explanation that makes the fewest assumptions.

For decades, pseudo-intellectuals (like me) have been evoking Occam’s Razor whenever discussing (mostly) trivial matters.  In my experience, those who unsheathe this rhetorical construct from their debater’s arms cache, more often than not, do so to show off rather than to defend their point of view.

Today I would like to use Occam’s Razor in two ways: 1) to show that most people seem to prefer the more complicated answer regarding capital markets matters, and 2) to use a simple answer to support my view that we are still in a bull market.

Anyone who follows the daily commentary about the financial markets understands that there are many opinions out there.  Those persons with the most extreme (non-consensus) viewpoints tend to be quoted more frequently than others.  I guess these ideas are considered more newsworthy than less flashy ones.  Recently, I have been bombarded by messages telling me to sell my stocks, buy gold, be prepared for massive inflation, be prepared for even more massive deflation, kiss the American Dream goodbye, feel sorry for my grandkids, expect another global financial crisis worse than the last one, etc.  We hear from Nobel-winning economists that the stock market is overvalued.  We hear that billionaires are selling their stocks.  We hear cautious words from big hedge fund managers.

As outrageous as these viewpoints may seem to me, some people must be seriously considering them.  Each week or so, I receive a forwarded e-mail from a friend, colleague or client stating that the “end is near,” and that the author of the e-mail has the perfect investment product for the apocalypse.  In my view, the vast amount of material like this argues that the general public is looking for a complex answer to the simple question, “Where are stocks going?”  The best simple answer to that question, in my view, is “higher.”  Stock prices, over time, always move upward. In any given year, the markets can experience volatility and price declines, but in the long run, stock investors (who remain invested) always make money. So, the Occam’s Razor answer to the question about the market’s direction could be “higher” (over time).

The current debate about the fragility of the stock market seems to center on 1) the fact that many major indices are at all-time highs and 2) the bull market is old – the “average” bull market lasts about 5 years – right where we are now.  Those calling for a bear market are not content simply citing the above facts; they will buttress their argument with 1) worries about the impact Fed tapering will have on stocks, 2) China’s slowdown, 3) Europe’s on-going problems, 4) wars and rumors of war in divers places, 5) esoteric market technicals (remember the Hindenburg Omen?), etc.

In my view, the bear argument tries to win using a large number of data points much like a lawyer would trying to establish reasonable doubt.  For me, the small amount of my research effort dedicated to macro issues (most of my research effort is spent on individual companies) tries to address the simple question, “Is there a recession likely within in the next 6 months?”  Bear markets usually start in front of a recession. Sure, sometimes a bear market can sneak up on us, but most of the time, they happen because of a looming recession.  If your answer to the simple question posed above is “no” then you (like me) can feel somewhat confident that the bull market is likely to continue.  It’s a good idea to keep a weather eye on the horizon looking for early signs of a recession, but for now “steady as she goes” feels better than doing something dramatically different.  One simple question plus one simple answer equals portfolio peace of mind.  William of Ockham would no doubt be proud…

* Many thanks to Ian Lawton and his website “Soulseeds” ( for sharing this joke with me

What to do in a Bear Market

I have been hearing enough chatter out there about the possibility of a bear market to feel compelled to comment on such nonsense.  First of all, bear markets do not occur when everyone is worrying about them.  The large number of warning articles I have seen lately, if anything, is probably a signal to buy, not sell stocks.

Second, most of the doom and gloom commentary comes from financial theorists, not practitioners.  Why anyone would take serious investment advice from journalists, economists, or academics continues to baffle me.  Assuredly, many of these professionals are highly intelligent, possess keen insights, wield superior analytical skills, have won numerous awards, and may have countless professional successes. However, none of these accomplishments necessarily qualify them to help us make money in the capital markets.

Third, any serious investor knows the tell-tale signs of a bear market, and would have to admit that almost none of the typical harbingers exist right now.  So let’s review what history can tell us about bear markets.

1)   They almost always begin six months before the beginning of a recession.  If someone can produce a credible analysis suggesting a recession by the end of 2014, I’d love to see it.  No credible economist is predicting recession in the foreseeable future.   There have been 14 recessions since 1929 and bear markets occurred in every one of them.  I am not sure how many recessions have been forecasted over this period, but I’m sure it’s much higher than 14…

2)   They occur after a period of considerable tight money policy by the Federal Reserve.  The current forecasts suggest that the Fed may begin raising the Fed Funds rate (the first step to tighter monetary policy) sometime in 2015.  There is a big difference between less easy money and tight money.  When we actually see tight (and not just “tighter”) monetary policy from the Fed is when we should begin to worry about the bear.

3)   Bull markets end (and thus bear markets begin) when the mood of investors is “euphoric.”  Some commentators are trying to paint the current mood as overly enthusiastic (obviously this is a judgment call – there are no infallible metrics for this), but I’m not feeling it.  The large amount of Initial Public Offerings is a yellow flag, as is the large amount of cash flows into equities and equity mutual funds. Yet, many of the sentiment measures are mixed – not suggesting any widespread euphoria.

4)   Bear markets often occur after a binge of borrowing.  Increasing usage of debt can often fuel the final stages of an economic recovery. People who are feeling confident about the future will borrow money to invest, expand their business or simply buy stuff.  This can lead to stretched balance sheets that reduce financial flexibility and can produce cautiousness that often causes, and then exacerbates, an economic slowdown.  Debt levels at the corporate level are far below those seen at normal economic peaks.  Household debt has started to rise again, but remains well below cyclical highs.

5)   Bear markets often begin when corporate profits and margins begin to fall.  It seems that nearly every quarter since 2010, some strategist was out there predicting the end of the current earnings growth cycle.  So far, all of these forecasts have been wrong.  Consensus estimates suggest another record year for corporate profits in 2014.

There may be other factors coincident with bear markets, but I think the items above are sufficient to conclude that a near-term bear market is next to impossible.

So back to the question at hand – what to do in a bear market? For someone possessing perfect foresight the answer is easy – sell all stocks and reinvest when the market bottoms.  For the rest of us, the formula is more problematic.  Selling stocks in times of worry feels very intuitive and doubtless provides the seller with some comfort.  More often than not though, it is exactly the wrong thing to do.  But, let’s suppose one does raise cash in front of a bear market, what then?  Holding cash as the market declines may feel good (offset by the sinking feeling caused by the shrinking paper value of one’s portfolio), but will that same seller have the fortitude to buy back the positions sold near the bottom of the market?  Human nature suggests that this is very unlikely.  We still hear about people who sold in 2008 or early 2009 who are still holding cash.  They were paralyzed by the market’s decline and could not bring themselves to re-invest.  The saddest part of this development is that the market has recovered all that was lost in the 2008-2009 bear market and more.

Ironically, the person who made no changes to their asset allocation during the last bear market likely did much better than anyone who tried to trade in response to it.

Do you recall anyone who told you to sell stocks in October 2007 and then buy them back in March 2009?  Me neither…

So what do I do in a bear market?  Usually, I stay fully invested and do not make changes in my asset allocation.  In the late 1990s, I had actually raised some cash in my portfolio (only time ever) because I thought the euphoria about tech and telecom stocks was way over the top.  I was fully invested in October 2007 and by late 2008 thought that the bear market was over!  As wrong as this opinion was, I did not waver in my resolve to remain fully invested through the bear market and I did.  Although it was more severe than most people expected, it lasted just about as long as the average bear market.  I was greatly rewarded for my discipline and resolve, and my portfolio is much larger than it was in late 2007.  I know a lot of people whose portfolios have likewise prospered by remaining true to their asset allocation and investment discipline.

It’s important to note that most investors with longish investment horizons (five years plus) should be able to easily endure the average bear market.  The last bear market was highly unusual and even more unusual was the flat stock market period from 2000 to 2010.  One must remember that this “lost decade” began with the biggest stock market bubble of this generation.  The last time stocks flat-lined for ten years was in the 1929-1939 period. That seems about right to me.  We can expect a massive bear market like we saw in 2008-2009 about every 80 years or so.

To sum up, I see no bear market on the horizon.  Most investors can endure a typical bear market without any dramatic portfolio changes.  Excessive happiness may be the best predictor of a bear market.

And I Would Walk Five Hundred Miles

Actually, I drove 500 miles this weekend to visit friends in New Jersey.  It was a wonderful experience and a welcome change to my regular routine.  I spent 25 years in the NYC/NJ area, so in many ways, this weekend felt like going home.  I’m not sure I gained any revolutionary investment ideas from the trip, but here are a few observations and conclusions (proclamations, if you will) from the journey:

Driving the “back way” via Pennsylvania is more scenic than driving on I-95.

Parking on the street in Manhattan is actually possible – not just an urban legend.

Hipsters abound in SoHo.

Big beards are de riguer in SoHo.

One can buy a monocle at the Warby Parker store in SoHo.

Everyone looks famous in SoHo (except U.S. tourists – European tourists look pretty fabulous, really).

People are very friendly on Canal Street – they will buy your gold and sell you really shiny watches with brand names on them.

Chinatown has grown geographically.

You can find very good Italian food (and mini cannolis!) in Little Italy (which seems to have become smaller, geographically).

“Baked by Melissa” mini-cupcakes are delicious.  The 100-count box sounds perfect for some occasions.

I know where one can buy a nice collection of stuffed Indonesian bats, framed and suitable for hanging.

The High Line on the West Side is a fun way to see some of the City, and stands as a monument to the persistence of residents who wanted to doing something to make the City better.

In Washington Square Park you can still:

  • hear bad solo Shakespeare,
  • hear college-age jazz trios (acoustic guitar, double bass and saxophone) playing Beatle songs, and
  • buy an original joke for $1 guaranteed to make you laugh.

NHL hockey games are loud.

Martin Brodeur is still a great goalie.

The U.S. remains a great place for employment opportunities.

Young people can still find many reasons to be optimistic about the future.

Sometimes an orange Jeep may be as cool as a Tesla.

Good friends are more valuable than gold or diamonds.

Smart and disciplined people can easily manage their investments, unless they have jobs, families or hobbies.

Random Thoughts on Passive Investing

I am an active investor.  I am not a passive investor.  A passive investor is one who buys “the market” or some other kind of “index fund.”  The premise behind passive investing assumes that because the “average” mutual fund does not consistently beat the market, one should avoid paying mutual fund fees and simply buy low-expense index funds and exchange-traded funds (ETFs).  Active investors believe that through hard work, discipline, creativity, experience and curiosity, one can beat the market, consistently, over time.

The debate over passive versus active investing has been raging for decades.  The real issue preventing a definitive conclusion is that measuring the performance of the two approaches is nearly impossible.  When I say “nearly impossible” I mean that anyone can use the historical data to convincingly support either side of the debate.

Here is one great example:



Clearly, the author of this graphic is pro-passive investing.  These numbers are convincing.  One look at these data would be enough to force an investor out of actively managed funds straight into the arms of passive vehicles.  Only when one looks at the source of this data does the bias presented here become clear.  These returns represent a six-month period in 2011, a timeframe when most active investors (including me) struggled mightily to beat the S&P 500.  Is it reasonable to use this extremely short period of time to settle the issue of passive versus active?  I think not.

So how many years of data should one use to tackle this debate?  Five? Ten?  Thirty-eight?  Because the markets are so complex and dynamic, one can find periods, even longish periods, where one approach seems to work better than the other.  Thus, many of the studies I read which attempt to settle this issue can be subject to a timeframe bias.

Another difficulty I see in broaching this issue is defining active investing.  An index fund is designed to track the market and charge a lower fee than the average mutual fund.  Some mutual funds have shown the propensity to “closet index;” that is, they claim active management, but tend to invest much closer to the index than one might expect.  These funds enjoy higher fees than a true index fund, and because they only marginally differ from the index they are unlikely to ever show massive underperformance.  They are equally likely to never show significant, consistent outperformance.  There has been a trend over time for many mutual funds to drift this way.  Herein lies the measurement issue – are these funds “active” or “passive?”  No active mutual fund portfolio manager would ever admit to being a “closet indexer.”  Hence, all of these funds, which have grown as a percentage of the total universe of mutual funds, would be lumped into the “active” bucket for comparative analysis.  The fact that many of the “active managers” in the studies look and act like passive investors can only lead to more confusion about which approach is better.

Into this debate steps Antti Petajisto, who at the time he published his research in the July/August edition of the Financial Analysts Journal was a professor at the NYU Stern School of Business.  He looked at thousands of mutual funds over the 1980 to 2009 period and made the following conclusions:

a) Three broad styles of “active investing,” namely, “closet indexers,” top-down macro investors and concentrated stock pickers – underperformed the market.

b) Diversified stock pickers, who were willing to measurably deviate from the indices against which they were measured, tended to beat the market.  He found that the portfolio managers who focused on stock picking and fundamental research (as a group) did better than the market.

Stock pickers can sell overpriced stocks before they collapse and then buy them back when they become cheaper.  Index funds cannot do this; in fact, they buy more of overvalued stocks and sell the undervalued ones.  Stock pickers can choose to include stocks in their portfolios based on fundamentals and valuation.  Index investors buy stocks as determined by the governing body of the S&P 500 (or other indices), based on factors which may not always be fundamental.  Stock pickers can determine whether or not a company is being smart in its use of its balance sheet and cash flow.  Stock pickers can measure the quality of a company’s management.  Passive investors can do none of these things.

This essay will likely not change anyone’s mind about the merits of passive versus active investing.  Yet, I would hope that my words might have raised some doubts to the notion that the “average” fund managers cannot beat the market.  The average ones may not, but the best ones (diversified stock pickers) can and do.

I am an active investor.  I’ve been doing it my entire career.  It works for me and for those who place their trust in me.

Investing is Like…


One of my favorite jokes is about the farmer who won the lottery.  When asked if he had any special plans for his lottery winnings, he responded, “Nope. Not really.  I’m just gonna keep farming until all the money is gone…”

That joke always gets a few chortles and knowing nods of agreement whenever I tell it at family gatherings (my wife’s family is in the farming business.)  Anyone who knows anything about farming understands that it’s a tough endeavor.  Even if a farmer does everything perfectly, the randomness of weather, disease or other natural disasters can greatly affect the outcome.  Yet, in aggregate farmers produce enough food to feed the nation, satisfy massive export demand and make enough money to buy seeds, fertilizer and equipment to stay in business year after year.  As I pondered on this, I realized that investing (at least the way I do it) is a lot like farming.

This month I made 393 equity and mutual fund trades.  As I executed these trades, I was struck at the wide variety of outcomes among the names I traded.  Some names had been held a long time (over five years); others only a few months.  Some were up a multiple of their purchase prices; others lost money.  Each name told a unique story from the date of purchase to the day I sold it.  As I mused on this notion, I realized that at the time I had bought each and every name, I expected it to make money, probably as much as 30% over some reasonable time frame.  The fact that some lost money and some went up 300%, doesn’t necessarily suggest that I don’t know what I’m doing – it simply underscores the uncertainty inherent in equity investing.

Like the farmer, even when I do all that I can do to assure that a name is likely to produce an attractive, above-market returns, I am always subject to the risks associated with investing.  Sometime, this risk is company specific.  A company can report a disappointing earnings number or be subject to some government inquiry.  Sometimes the risk is macro in nature – the market moves up or down on some big development (Fed action, natural disaster, China slowing down, etc.).  Sometimes there are just more sellers than buyers (or the other way around) affecting the price of a stock.

Taking the farmer analogy even further, some investors only look at “the “market.”  They buy and sell “the market” and talk exclusively about “the market.”  This is kind of like a farmer planting only wheat.  All he cares about is the price of wheat and the many factors that influence this one crop.  A value investor like me who creates well-diversified portfolios using individual stocks, is more like a farmer who plants many different crops, in several locations throughout the world, with varied growing cycles, weather conditions, yield expectations, uses some greenhouses and maybe even tries experimental crops or hydro farming.  Because I am not investing in one thing (“the market”), I get to see each of my names mature, grow and blossom at different times.  Sometimes, the growth is utterly surprising on the upside.  At other times, the fruit withers on the vine or doesn’t even appear.  Sometimes, the harvest season comes early; sometimes it seems to take forever.   Over time, I expect the sum of all my individual names to generate attractive returns for my clients and me.

The bottom line for me is that it always seems to be a good time to be planting and harvesting.  The investor who only owns “the market” is probably worrying about either sellilng or buying – is it time to plant or reap?  My way of investing allows flexibility and yields a bountiful cornucopia of diversified fruits of my labors.  Worries about the emerging markets, Fed policy, retail sales, government actions, and so forth, can and will impact “the market” and my investments.  Yet, taking the longer view and understanding that market declines represent buying opportunities (planting) and that times of euphoria can be selling opportunities (harvesting) makes my job much easier than just buying “the market.”  Or farming for that matter…