Investing debate: Passive versus active investing

The Investor and The Accumulator rain death blows upon each other as they grapple for supremacy of the investing universe. Catch up on Episode I and Episode II, then read on as The Investor tells us why he fears not the market…

The Accumulator has just asked him why he thinks he has investing “edge”?

The Investor: Hah! Well to answer your question literally, I think I have an edge because I have the same faulty brain chemistry as everyone else, and thus have the personal exceptionalism bias, or whatever it’s called. (I’m sure you’ll remember…!)

Primarily, I guess I don’t think I do have an edge as much as I think most others don’t. If most other investors do worse than a few, than the few can win.

So to turn to the opposition: private investors first.

Obviously I don’t know every private investor out there, and have in fact only been exposed to a small subset through either real-life or through virtual forums. Some sound very good and plausible. But the majority of even the better sounding ones definitely exhibit, in my experience, what Oaktree’s Howard Marks calls first-level thinking – they think the obvious and forget the extent to which everyone else could also be thinking the obvious.

Instead, an active investor needs to think of the obvious and what everyone else thinks about the obvious (and why). And they also need to consider what the smart second-level thinkers think, so we’re onto third-level thinking, and so on.

Now, you might argue that even second- or third- or ninth-level thinking is (a) increasingly unreliable with each derivative and (b) discounted somewhere else by the market, and I’d agree it probably is.

But I’m pretty sure most of the amateur opposition doesn’t go much further than first-level thinking.

Note: I’m not even counting the downright bad stock pickers I regularly come across, who barely seem to engage in first-level thinking, who can’t do sums, who don’t read up on their companies, who over-trade, blindly follow tips, and so forth. They’re a huge bunch, too. Naturally they can win like dart-throwing monkeys – i.e. by luck – but obviously I wouldn’t bet on it.

What about the pros? When it comes to mainstream funds, I think a lot of them are constrained by issues such as benchmarking, herd mentality, and career risk.

In fact I’d say career risk is the biggest issue for them. It’s far safer to fail slightly than to fail big trying to win big, whether it be through stock selection, sector selection, market timing or anything else. They are incentivised as much not to lose as to win, in any given year.

The whole industry is structured that way. Hence the preponderance of those closet indexers – supposedly actively managed funds that basically mimic the market but charge investors much higher fees than our beloved true trackers.

In contrast, as a private investor I can buy what I like, go in and out of cash as I choose, and invest anywhere unconstrained by being told it’s not in some index or another. I can lose 50% of my money on a share and nobody needs to know.

Another group that sounds like are hedge funds, and it’s true they can do these things, too. But if they’re any good then hedge funds usually scale quickly to become lumbering and then are often just as inclined to keep assets as to keep trying to win as the traditional vanilla active funds we’re all more familiar with.

They also rapidly get shut out from the asset classes most likely to reward good judgement (if it exists) or most likely to offer higher return premiums (e.g. small cap value). And after all that they need to do well enough to pay for their eye-watering fees…

Then you have the passive crowd, who by definition aren’t playing.

So in my mind that’s a lot of the competition doing sub-optimal things.

Of course, the pros do have researchers and analysts and direct-market access and investigative journalists and the ability to lever up / down at will and so on and so on. Who knows if that negates the hopes I cling on to of a relative edge?

What about me? Am I wired differently?

Here I can say that I have evidence that I am. All my life I’ve been a bit different, have tended to offend by accident, am argumentative [I can vouch for this! – TA], am happy to hold unpopular views, and I’m not overtly emotional. I think all those things help.

I am also a bit OCD, in the correct (if very mild) sense of the term.

Since getting into investing, it’s the main thing I do. Other potential money-spinning ventures have largely gone by the wayside. I regularly read company reports at midnight, and check the latest stock market news at 7am, and thumb through investing books with my bacon sandwiches on a Sunday morning.

Is any of that enough to have an edge? Perhaps not. Perhaps the opposite. But that’s partly why I think I might.

I am not left-handed

The Accumulator: Wall St whistleblower, Charles Ellis, author of Winning The Loser’s Game said, “Don’t confuse facts with feelings.”

I hope you do have an edge, I really do, I’m kind of taken by your notion of your nippy little speedboat weaving under the guns of the ponderous battleships of Big Finance. But I don’t buy it – it’s too romantic. I’m glad you’re taking the risk, not me.

I think the bulk of private investors pulling shapes on The Motley Fool are neither here nor there. It’s the pros who account for the majority of the flows and that’s who we’re up against.

There are thousands of them out there and Lars Kroijer describes in detail their superior firepower: the astonishing access to information, analysts and computing power, and their first-name familiarity with the senior management of the stocks they follow. That section of Lars’ book is a fascinating insight into the enemy camp and it’s scary.

It’s interesting that you suggest fund managers are incentivised as much not to lose as to win… If the professionals have come to recognise that the best way to succeed is to collect the market return then maybe that tells us something? Sure, the private investor can lose big and only they need know, but they’ve still lost big! They’d probably be better off if they sacked themselves.

The paradox is that none of us can know until it’s too late. You need 20 years of results to prove you’re an investing ninja, by which time it’s too late if you’ve misjudged yourself. Again, it’s about the balance of risks.

I think it’s telling that many private investors don’t accurately measure their returns and costs over the long-term – why spoil the dream?

Now, don’t get me wrong. I definitely think you’re wired differently from most. Your resolve in the face of the cutest puppy amazes me.  Your intellectual ability and investing knowledge is enviable. These traits set you apart from Main Street. I’m not sure you stick out so much in the City though.

That said, should you hit the jackpot, do remember I’ve supported you all the way. 100%. ;-)

I am not left-handed either

The Investor: Thanks for the kind words – although I know you know me well enough that “you’re wired differently from most” is not entirely a compliment in my case. ;)

And I know the City is full of smart cookies. Doubtless many with (even! ;) ) more intellectual firepower than me, but crucially I’m not sure that’s really what’s required once you can tie your own shoelaces and use a search engine.

All that said, I really wouldn’t be too in awe of the professionals. I’m not.

This article by Morgan Housel, for example, shows how useless analysts are when it comes to calling stocks. Now granted, analysts are screwed over by different incentive problems, career risk issues and behavioural biases than fund managers, but same sausage.

I’m heartened to read in Housel’s article that anyone following analysts would have done better by literally betting on the opposite of all their predictions, in aggregate. Many of these guys only follow a handful of stocks, in one sector, and they still can’t get it right, with all their money, research departments, water coolers, and lunchtime briefings with management.

You see that as daunting, and it is because it shows how hard it is. But it doesn’t show the professionals are any better than me at picking shares that will do better than other shares. Not to me, anyway.

Please don’t misunderstand – I think the pros are fearsome competitors. Your nautical parallels are nice, but the image that actually sprang to my mind was that scene from Terminator set in the future, where dozens of giant killer robots stalk a barren landscape, using flood lights and powerful weapons to zap the puny human resistance.

I’m not driving one of the robots in this image! But, equally, the puny human resistance lingers on…

Still, the horrible truth, as you correctly diagnosed last summer, is that I am addicted to this and probably would do it regardless. I think I have a good crack at beating the market, from what I know about myself and some clues from results to date.

To that end I’ve sent you some bits and pieces for trust and verification purposes, but I don’t want us to go down the road of printing numbers here. I won’t say I’m too humble (you won’t fall for that!) but (a) I don’t want to encourage people – I genuinely believe most people are better off in tracker funds, as I stressed at the start of our conversation – and (b) my longer-term returns data is as statistically robust as a Mori poll about promiscuity taken in a convent and (c) it could all be, until the day I die, luck.

Do I have an edge, or do I just have an addiction?

I am not sure. I don’t lose any sleep worrying about whether I’m taking an excessive risk (beyond the general risks of investing in shares and so on) by trying to add alpha, but I do spend fretful hours now and then wondering if it’s bad for my being.

We only get one life, and investing has become a bit of an obsession. The novel is looking even more unwritten than that of the average going-to-write-a-novel would-be novelist. Heck, I don’t even read novels anymore. I read annual reports. I don’t settle down or have kids – I churn my portfolio.

I don’t know if this is terribly sad, or if I’m lucky to have found a passion. I don’t really care about money the way a lot of people do. But I like loving something that I do, and I like keeping score.

Ultimately, as I said at the start, this is the reason why I actively invest. I will agree after all our chat that the possibility I might beat the market is clearly in the mix, but I still think it’s a means, not an end, for me. Which is pretty much the opposite of how it works for most people, for financial services, and probably for common sense.

In summary, please don’t worry about me. Edge or not, I’ll be fine. I think I’ve seen signs that I’ll do better managing my own money than any alternative, but the fancy word for clues that gamekeepers use to hunt deer is spoor, and spoor is basically sh*t. Which is about what those signs are worth so far, statistically speaking, and about what I’ll give if I end up 50% down from where I might have been if I’d never tried at all.

It’s only money.

All the best and Merry Chrismas!

The Investor

I would as soon destroy a stained-glass window…

The Accumulator: You are lucky to have found a passion. Passion is the most sustaining force of any human life. It can drive us on to great things. Whether you are lucky your passion is investing… we’ll find out in 20 years!

You quoted ISA millionaire John Lee recently:

In my view, to be a successful investor requires commitment and time, and you’re only going to put in the required effort if you find the stock market enjoyable and absorbing.

To be blunt, either you fall in love with investing – its fascination and its mysteries – or you don’t. You will know soon enough which it is.

This perhaps crystallises the difference between us. I enjoy it, but I don’t love it. I am comforted in my choice by the weight of evidence, academic research, and wisdom marshalled by the superstars on my team. You have a long shot at stupendous success and a slam dunk at doing something you love.

The important thing is that our choices square with who we are – investor know thyself – and I think you do.

Well, I feel like a British Tommy who’s just played an enjoyable score-draw with his Pickelhaubed Hun adversary in No-Mans-Land. It’s time to shake hands and withdraw to our respective trenches while the strains of Silent Night drift across the blasted field.

This is one struggle that won’t be over by Christmas, but I wish you a happy one all the same.

The Accumulator 

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