Wednesday, September 12, 2012

Active and Index Investing

A few weeks ago I received the following comment from DTEJD1997 on yahoo stock boards. I want to share it here because it just warmed my heart.
Keep up the good work.

I was going to say that working for yourself will likely beat most mutual funds over a long period of time. Of course, you have to be willing to work several hours per week, EVERY WEEK.

Think about this...I personally know some investors who are totally self directed. All they do is buy stocks, bonds & options. Never a mutual fund or any actively managed device (well maybe 1% or 2% of assets in funds).

They will trade 1-10 times a month. They very frequently hold positions for YEARS, sometimes DECADES. They use an online discount broker that trades for $10/leg. They probably spend $300 to $600 a year on commissions. This is for a SEVEN figure portfolio. Compare that to an actively managed fund that charges 1.5% or 2% of assets a year. We could be talking about $15k to $25k a year in fees and expenses! How much does that add up to over 5,10,15 years?

If you have the patience and are willing to work at it, over the decades you will become VERY wealthy following the "value" discipline.

Keep up the good work!
His sentiments reflected mine. The person he described can be a retiree. The retiree can have a 7 figure portfolio, and is willing to do her own work. She can save $15-25k a year after tax! That along with retirement benefits such as social security is enough to live on comfortably. Or it could be someone who chooses to work part-time and invest in the remaining working hours. That's enough to live on comfortably pre-retirement.

I think the general public does not realize how much the financial industry gouges us common folk for their very mediocre service. Numerous studies have shown that 85% of mutual funds lag the general market, which for Americans would be the S&P 500 index. So unless an investor is positive she can consistently find that 15% of above average funds, she might as well just buy an index fund. This is the Jack Bogle's investment thesis (Bogle is the founder of Vanguard funds, a pioneering in the index fund industry).

So I started investing by making some foolish mistakes which I won't mention. Then I settled on indexing. But later, my methods evolved to more active investing. Active investing to match the market index has inherent advantages. Firstly, it saves on management fees which, although are low for index funds, are still my money. Secondly, it allows for greater tax efficiency such as realizing tax losses when I need it, or allocating certain stocks to tax-sheltered accounts and the rest to non-tax-sheltered accounts. And thirdly, it allows me to learn to be an active market-beating investor. If I don't do active investing, I will forever be paying others to invest my money.

So, I started active investing by trying to track the market. In another sense, I am just trying not to lag the S&P 500. But the S&P 500 is a basket of 500 stocks. I cannot practically own 500 stocks. I don't think I can even own 30 stocks of the Dow Jones Industrial Average. But then I found that studies have shown one can track the market with as little as 12 stocks, so long as they are diversified. And so I bought a dozen or so stocks that are generally indicative of the US stock market. And to this day I own one or two stocks in each of the following big categories:
  • consumer staples
  • consumer discretionary
  • high tech
  • foreign stocks
  • energy
  • basic materials
  • healthcare 
And I can see that as a result of this strategy my returns have matched or beat the S&P 500.

After I was able to match the market, I gradually evolved to trying to beat the market with large cap value investments. My way is to follow the big active value investors. All fund managers managing $100M or more are required to file quarterly with the SEC. So anyone can copy the legendary active investors with just a 3 month lag. How easy is that? The only hard part is knowing who the legendary investors of our time. Legendary value investors to me must have a long track record of outperformance through good and bad market conditions. The following are some that I can think of right now:
  • Warren Buffett, Berkshire Hathaway
  • Bruce Berkowitz, Fairholme Fund
  • Francis Chou, Chou Fund
  • Bill Ackman, Pershing Square
  • Don Yacktman, Yachtman Fund
  • Robert Bruce, Bruce Fund
  • Prem Watsa,Fairfax Financial

By buying what these masters own, especially if multiple own the same stock, I think I can do better than the market . After all these investors have all proven they can beat the market for 10, 20 years or more. And all this is with low fees, low risk and low maintenance.

Recently, in fact in the month since I started this blog, I have evolved yet again. Now, I have begun to invest in small caps, where I hope there is big underpricing. I hope to beat the market with such stocks because this is where where the big guys cannot participate; the gains are just too small to matter to those with billion dollar portfolios. But that's the topic of another post.

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