My friend Josh Brown wrote a great blog post about active portfolio management. It sparked so many thoughts, so I’ll try to sum them up in the following points:

1) I talk to many potential investors who ask me “why should I have an active strategy when the market is doing fine and keeps going up?” OF COURSE when the market goes straight up for 4 years, a buy and hold (passive) strategy works well. You’ll pretty much perform in line with the averages and outperform many active strategies. The problem is, when (not if) we get a deeper correction, all those people are going to ride the wave down too.

2) Over the past 4 years, we’ve had some decent corrections (roughly 15-20% in 2010 and 2011). Keep in mind that these corrections did not last long. If you went away for the summer and came back a few months later, the market was back on new highs and you probably said to yourself “what correction?” Remember, time is what kills people. In other words, when a stock or index goes down and snaps back relatively quickly, investors are ok with that. When a correction endures for a while, that does serious damage to investor psychology.

3) People forget things so quickly. During the decade from 2000-2010, the market went nowhere. We had 2 corrections of approximately 50%. During that time, I know some active managers who averaged 10-15% PER YEAR. Again, when it’s great (as is has been recently) everyone wishes they had a buy and hold strategy. When it’s below average (as it was from 2000-2010), everyone wishes they had an active strategy.

4) A passive strategy is great for retirement. Many of my friends have 401k plans at their work (managed by their plan administrator). When they ask me what mutual funds to put it in (as they usually have a selection of 8-15 funds), I tell them to put it all in the S&P 500 Index Fund (if their plan offers that choice). Two reasons for this: 1) For those who say “it’s not enough diversification,” my response is “How is putting your money in 500 Multi-Sector and Multinational Companies NOT diversified???” 2) 88% of mutual funds can’t beat the S&P 500. In other words, if you choose from the other funds that your company plan offers, you have roughly a 9 in 10 chance that it will underperform the index. Therefore, you are better off just putting it into the index and adding to it on a regular basis.

5) Barry Ritholtz wrote a blog post about how hedge funds (an active strategy) have underperformed recently. Many hedge funds I spoke to said their weak performance is due to shorts eating into their long profits. For the hedge funds who are long-only or long-biased, I agree with Barry that their underperformance is due to risk aversion. All I have to say to those hedge funds is: If you are only up +3% while the market is up +15%, you better only be down -3% if the market corrects -15%.

In conclusion, it seems like everyone wants the best of both worlds. They want to be in the market when it’s going up and out when it’s going down. In interest of full disclosure, I am an active manager. I believe you can outperform the market by being in strong stocks during the market uptrends and reducing exposure during the downtrends. Some people say this is impossible and “you can’t time the market.” I hate that expression because it assumes you are getting in at the dead low and out at the absolute high. OF COURSE THAT CAN’T BE DONE! However, you CAN catch the bulk of an uptrend and AVOID the bulk of a downtrend.

Here’s the biggest problem: Doing this involves PUTTING IN THE TIME!!! In addition, you need experience, confidence, flexibility, little ego, the ability to decipher when the market is healthy and when it’s not, the ability to read price action, the ability to select strong stocks, and most importantly…the ability to make decisions! This challenge is why I love active management. No doubt it’s difficult, but I’m willing to put in the time and effort, especially because the market is constantly evolving. It’s against my religion to put client money in mutual funds and ETFs, leave the portfolio, collect fees and then tell them to “ride it out” when we have a correction. That’s what most people do and I refuse to be most people!

I’ll leave you with this thought. I think it’s important in life to find something you’re passionate about and really strive for excellence. Going through the motions and being average like everyone else is completely unacceptable in my book. For me, one of my passions is the challenge of outperforming the market. Very few can consistently do it, but that’s why I love it…because very few can do it.

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