The Skills It Takes To Be A Great Active Investor

Investing — like life — is all about probabilities. While we don’t know what is going to happen with certainty in the future, we can at least predict a range of possibilities as to what might happen.

The ability to predict these possibilities and assign a range of probabilities to various situations is what separates the successful investors from the unsuccessful.

Now, the verdict is out that a passive strategy beats an active strategy for the average investor over the long haul. Active strategies don’t even come close over a 30 year period.

Passive strategies are great for retirement. Many of my friends have 401k plans through their work and when they ask me what mutual funds to put it in (usually a selection of 10-15 funds), I tell them to put it all in the S&P 500 index fund (if their plan offers it). The reason is that something like 90% of mutual funds underperform the S&P index after all the fees. And then for everything else beyond their 401k I tell them about the ideal passive investment mix and direct them to Wealthfront. You’re just far better off putting your leftover funds into a diversified mix of low cost index ETFs and adding to it on a regular basis (i.e. dollar cost averaging).

However the main problem with passive strategies for the short term is that when (yes, when not if) we get a deeper correction, all those people are going to ride the wave down too. Another 2008 comes along and you’ll see your mix drop by 50%. Whereas some good active managers could still average 10-15% up in those down years.

So I do believe there is a place for active management in addition to your passive retirement mix. And not just for the super rich few that can afford the high multi-million dollar minimum commitments at elite hedge funds like Ray Dalio’s Bridgewater Associates (his flagship fund Pure Alpha has been up an average of 14% a year since 1991). I think there’s a place for active management for the many who have extra cash outside of their 401k and IRA retirement funds.

In the interest of full disclosure, I’m trying to be an active manager. I treat it as a 2nd job. I love stocks. And I’m not ashamed about it. I invest in stocks actively not to keep pace with the averages but to crush them. And I have funds with other active managers who are trying to do the same.

Now there are many ways one can be successful in the markets, albeit they are all hard to find and carry out. The main way I try to is by being in strong stocks during market uptrends and reducing exposure during the downtrends. (I’m not a big fan of shorting because I feel it is too difficult and frustrating but that’s for another blog post).

Of course you can’t “time the market” — you can’t get in at the very bottom and get out at the very top. And you shouldn’t try. But you can catch the majority of the uptrend and avoid the majority of the downtrend. As Howard says: follow the money, you don’t need to be first and you should never be last.

How?

In my opinion, here are the main skills it takes to be a successful active investor or trader:

  • Willing to put in the time. By far and away the most important. It mainly makes time to learn. The best managers put in the time. They learn the language (Stocktwits is a great place to start), they read lots of books, keep up with the press coverage, constantly watch the market, run through 100+ charts every night, etc.
  • Passion. The best investors I’ve seen truly love what they do. It’s the only way they are able to put in the time needed to become great.
  • Experience. The pros have seen it all. They’ve been through all sorts of market cycles. Long periods of sideways choppiness, uptrends, and downtrends. And not just the short term 15-20% corrections but the big 50% corrections too.
  • Adaptability. Markets change. And the strategies that were working in one market may eventually deteriorate. Good traders will change their methodology to match the new market conditions.
  • No ego. None. If you go into trading with an ego the market will eat you alive. The elite investors are able to admit when they’re wrong. They even embrace it. Being wrong quickly means they can move on to being right faster.
  • Emotionless. This goes hand in hand with ego. Along with pride, investors face a daily trio of emotions of hope, fear, and greed. The worst investors allow their emotions to control their trading; the best avoid any emotional attachment at all.
  • Patience. Many of the best have the patience to wait for the right opportunity to present itself. They don’t force it. As Jesse Livermore famously said, “Throughout all my years of investing I’ve found that the big money was never made in the buying or the selling. The big money was made in the waiting.”
  • Flexibility. The best managers are able to turn on a dime. Make a mistake? No worries. Cut your losses and get out. The greats do this without thinking about it. And will even reverse those positions if they are confident enough.
  • Risk Control. I saved this one for last on purpose. It all starts and ends here. The best investors always have a lazer beam focus on risk controls. This varies person to person but they never risk more than [insert some small number] percent of their portfolio on any individual trade.

One last thing I’ve noticed about the best investors, which is less of a skill and more of an attribute, is the motivation of the game. The best traders think of it as a game. They think of wins in terms of percentages, not money. Trading just to make money is always a bad idea.

No doubt this mix of unique skills is hard to come by. But that challenge is why I love investing. So I’m willing to put in the time and effort.

The Ideal Passive Investment Mix

I got a lot of questions on my active vs. passive management post about the asset allocation model I use for my long-term and retirement accounts. Again, this is separate from my actively managed accounts where I do all of my swing investing.

The mix is mostly based on Wealthfront’s research which is largely derived from Modern Portfolio Theory. They have a fantastic whitepaper that digs deep into their methodology if you’re interested in learning more.

But it’s essentially 7 asset classes bought through low-cost index ETFs:

The data shows that over the long haul (i.e. 10+ years) the above mix with rebalancing and tax loss harvesting will handedly beat almost all actively managed funds.

When The Dumb Money Becomes The Smart Money

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

- Warren Buffett, 1993 Berkshire Hathaway Shareholder Letter

I love this quote from Warren Buffett. And I love this post from Josh on The Paradox of Dumb Money.

A lot of people ask me where I put my cash and savings that’s separate from the momentum/swing investing that I do. I’m going to start directing them to here and to Josh’s post.

As Josh mentions, it’s not that Warren thinks that active management doesn’t work and that people can’t beat the market. In fact, he believes the opposite. Unfortunately, just not by many people and certainly not by the average person.

For many years people thought they were smart by getting someone “above average” with the Midas touch to manage their money. The idea is alluring. But fortunately they have wised up.

What used to be a debate about which is better for the long term investor, passive vs. active management, is all but nonexistent now. Virtually every piece of empirical evidence shows that an investor is better off with passive management (i.e. periodically investing in low-cost index funds) over active management (i.e. paying someone to pick their stocks for them).

Indeed, just last year the “dumb money” investor in their S&P 500 index fund earned close to 16% while the “smart money” hedge funds (via the HFRX Global Hedge Fund Index) earned just 3.5%. If we look back at the last five years, the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. And that’s just through 2012; it’s only gotten worse in 2013.

By becoming aware of their own limitations the average investor is showing itself to be smarter than ever before. The “dumb money” has started to become the “smart money.”

So no, I don’t invest in any active management funds. I’m sticking with the data and every month tucking some away into low-cost index funds. The asset allocation model I use is very similar to Wealthfront’s. Check out their great blog if you’re interested in learning more.

By the way, I do agree with Warren that the market can be beat though. Hence my heavy personal focus on swing investing. Finding the next Google or Tesla can certainly supplement your index fund returns. And if you do it well (proper risk management, stop losses, cutting your losers quickly and letting your winners run, etc.) it can push your total returns into the next stratosphere. Just know going into it that the odds are stacked against you.

The Four Phases Of A Bubble

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Interesting chart showing the four psychological phases of a bubble via Prof Jean-Paul Rodrigue.

To become a good investor, you have to be very prescient. If you can be in the “Stealth” or “Awareness” phases above then you are leagues ahead of everyone else. Of course the tricky part is that being too early is often the same as being too late.

But to become a great investor, you also have to master the psychology of bubbles and business cycles. So it’s important for investors to study these four phases and view each of their investments through this lens.

Here’s how Prof. Rodrique describes the four phases:

Bubbles (financial manias) unfold in several stages, an observation which backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically four phases can be identified:

Stealth. Those who understand the new fundamentals realize an emerging opportunity for substantial future appreciation, but at a risk since their assumptions are so far unproven. So the “smart money” gets invested in the asset class, often quietly and cautiously. This category of investor tends to have better access to information and a higher capacity to understand the wider economic context that would trigger asset inflation. Prices gradually increase, but often completely unnoticed by the general population. Larger and larger positions are established as the smart money start to better understand that the fundamentals are well grounded and that this asset class is likely to experience significant future valuations.

Awareness. Many investors start to notice the momentum, bringing additional money in and pushing prices higher. There can be a short-lived sell off phase taking place as a few investors cash in their first profits (there could also be several sell off phases, each beginning at an higher level than the previous one). The smart money takes this opportunity to reinforce its existing positions. In the later stages of this phase the media starts to notice with positive reports about how this new boom benefits the economy by “creating” wealth; those getting in becoming increasingly “unsophisticated”.

Mania. Everyone is noticing that prices are going up and the public jumps in for this “investment opportunity of a lifetime”. The expectations about future appreciation becomes a “no brainer” and a linear inference mentality sets in; future prices are an extrapolation of past price appreciation, which of course goes against any conventional wisdom. This phase is however not about logic, but a lot about psychology. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. The market gradually becomes more exuberant as “paper fortunes” are made from regular “investors” and greed sets in. Everyone tries to jump in and new intrants have absolutely no understanding of the market, its dynamic and fundamentals. Prices are simply bid up with all financial means possible, particularly leverage and debt. If the bubble is linked with lax sources of credit, then it will endure far longer than many observers would expect, therefore discrediting many rational assessments that the situation is unsustainable. At some point statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.

Blow-off. A moment of epiphany (a trigger) arrives and everyone roughly at the same time realize that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Some are fooled, but not for long. Many try to unload their assets, but takers are few; everyone is expecting further price declines. The house of cards collapses under its own weight and late comers (commonly the general public) are left holding depreciating assets while the smart money has pulled out a long time ago. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. There is even the possibility that the valuation undershoots the long term mean, implying a significant buying opportunity. However, the general public at this point considers this sector as “the worst possible investment one can make”. This is the time when the smart money starts acquiring assets at low prices.

Bubbles can be very damaging, especially for those who arrived late with the hope of getting something for nothing. Even if they are inflationary events, the outcome of a bubble’s blow off is very deflationary as large quantities of capital vanish in the wave of bankruptcies and financial defaults they trigger. Historically, they tended to be far in-between, but between 1995 and 2008 three bubbles took place back-to-back; the stock market (deflated in 2000), real estate (deflated in 2006) and commodities (deflated in 2008).

Investors Are Asking The Wrong Question

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Josh Brown had a post last week that really nails it. He cites a New York Times Business headline titled Investors’ Quandary: Get In Now? with the opening line:

“So is it too late for investors to join the party?”

Since last week, the markets have continued their march to new highs and the articles have gone from being on the Business and Finance sections to the front page. Every time I see one of these articles, I think back to Josh’s post so I thought I’d share it.

Here he is. Take heed:

What are they thinking? Have they seen the data?

If not, here’s a slice:

Between 1926 and 2010, there was not a single rolling 20-year period - pick the starting point in any month of any year during that eight-decade stretch you’d like - with negative returns for stocks. Hasn’t happened.

Keep in mind what went on during this 1926 to 2010 period - prohibition, a legendary stock market crash, a Great Depression, World War II on multiple fronts, Korean War, Red Scare, nuclear scare, Presidential assassination, Vietnam War, Disco, stagflation, oil embargo, Cold War, two wars with Iraq, Presidential impeachment, 9/11 and Afghanistan, The Credit Crash, housing crash, Lehman bankruptcy, $50 billion ponzi scheme revealed, bailouts and TARP, unemployment crisis, Muslim Marxist President elected, Euro crisis, etc.

Through all of that, not a single 20-year period of down stocks.

Between 1950 and 2010 - 60 years - the worst 10-year rolling period saw a decline of only 5.1% with an average annualized return of 7.3%. The worst 5-year period was a decline of 8.5% but with an average annualized return of 7.5%.

And people are in 100% cash because….?

So “Is now the time to get in?” is the wrong question entirely. The right question is “Why are you out in the first place?”

Read Also:

Wrong Question

All-In and All-Out

[Note, the photo above is one of my favorite sketches from Carl Richards. Like Josh, it sits on my desk to serve as a constant reminder.]

"Weird Science" as One of the Three Investment Themes for 2013

Josh Brown is out with his three investment themes for 2013. One of the three is what he’s calling “weird science” which includes new tech such as 3d printing and more:

3. Weird Science - when we think about the Tech Sector, we tend to think about Apple, Google, Intel, Microsoft, Qualcomm etc, and its easy to forget that these firms are anywhere from 10 to 30 years old at this point. In 2013, the hot money will flock to new technologies and off-the-beaten-path growth stories like 3D printing, electric cars, automation and robotics, etc. The next generation of tech giants are now stewing in a cauldron of midcaps, this year will witness their emergence into the big leagues.

I agree. 3D stocks such as $DDD and $SSYS have killed it over the past year, up 257% and 167% respectively. And I think their runs are far from over too. 3D printing stocks along with other new tech like robotics and electric cars are all investment areas I’ll be watching closely (and writing more about) in 2013.

Here’s a video on Yahoo Finance of Josh discussing this and his other two investment themes:

Facebook's Biggest Lockup

I’ve written before about Facebook’s lockup dates. Well their biggest lockup expiration day is here tomorrow. From CNN Money:

It’s déjà vu all over again for Facebook. On Wednesday, the company faces yet another day when millions of shares could hit the market — and this may the biggest potential stock dump by far.

Early employees and investors will get their first chance to sell about 773 million shares, as well as another 31 million restricted stock units owned by employees who joined the company prior to 2011. Like many initial public offerings, Facebook’s May 18 debut included a “lockup” agreement that requires some shareholders from selling for a certain period.

While I’m still bullish on the stock long term (especially after their last earnings release with mobile monetization improvement), I’m still wary in the short term. It will be interesting to see how many shareholders will be selling tomorrow and in the next couple of weeks. And how the market reacts to that selling.

(via Apple’s Hit-And-Miss Quarter In Charts) Here’s what else stood out to me: - iCloud now has over 190mm users, up 26.7% from last quarter — which means more customer lock in to iOS - Apple expects 80% of Q1 revenue to come from products released in the last 6 weeks — just, wow - Apple will have $121.3B in cash on the books after the new dividend — enough to buy all the teams in the NFL, NBA, MLB, and NHL - Facing supply constrain on ALL their new products: iPhone 5, iPad Mini, and iMac Going into the holiday season there seems to be a lot of pent up demand globally for Apple devices. It really will be all about Q1.
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(via Apple’s Hit-And-Miss Quarter In Charts)

Here’s what else stood out to me:

- iCloud now has over 190mm users, up 26.7% from last quarter — which means more customer lock in to iOS
- Apple expects 80% of Q1 revenue to come from products released in the last 6 weeks — just, wow
- Apple will have $121.3B in cash on the books after the new dividend — enough to buy all the teams in the NFL, NBA, MLB, and NHL
- Facing supply constrain on ALL their new products: iPhone 5, iPad Mini, and iMac

Going into the holiday season there seems to be a lot of pent up demand globally for Apple devices. It really will be all about Q1.