Active Investing – Potato’s Valve

August 5th, 2011 by Potato

I’ll jump on the active vs. passive investing posting spree. To sum up for those that don’t follow a hundred other blogs, there was something negative said about passive investing, in particular that it shouldn’t be attempted in a bear/sideways market. Well, how do we know we’re in a bear/sideways market? Passive investing is, IMHO, still a great choice then, as making that call on market direction is too difficult for most of us to even attempt (not that that stops us). So, good counters by Canadian Capitalist and Michael James.

I’m a bit torn on the whole matter myself. For one thing, I’m not entirely an active or passive investor, having my portfolio split into the active half and the passive half (though the halves aren’t quite equal, with the larger half belonging to the active part).

I completely see the logic of passive investing for the average person, and that’s all I recommend to people who ask what to do with their money. For the majority of people out there it is the right way to go: control your fees, be happy with “average” (though indeed, one can do better than the average investor with a passive approach), use your time to live your life. Or to put it another way, play to not make any errors.

But at some level 1) I think that superior returns can be attained (e.g.: the superinvestors of Graham-and-Doddsville) and 2) I don’t think that I am average, helped in part by 3) the fact that my dad is an active investor who has out-performed. The average investor/mutual fund has a short time horizon, lack of patience, chases returns, trades too much, over-values growth, under-values strong balance sheets, and is emotional. So I don’t think it’s a wonder that the average investor actually underperforms a passive portfolio, and moreover, I think that even a diversified passive portfolio can be improved upon. The problem of course is the Lake Wobegone effect: the average investor believes they are above average, and then makes mistakes that leads to underperformance.

There’s a tough line to walk there: value investors can and do underperform for long periods of time while waiting for the voting machine to turn into a weighing machine, so I want to be patient and stay the course if I have confidence in my analysis even when the market moves against me. But, I don’t want to brush away a lack of skill as a temporary underperformance. So I’ve created a set of rules for myself I call Potato’s Valve:

The money flow for the passive portfolio is like a one-way valve: money only goes in (until retirement). It gets first crack at new savings to at least make the registered account contributions.

The active portfolio started with most of my previous life savings, and can get a portion of ongoing savings as long as it’s performing. When out-performance stops (as it did in the first half of this year) the valve gets turned off and new savings go exclusively to the passive portfolio.

That protects me against the hubris of continuing to think I’m above-average when the evidence says otherwise. The passive portfolio will continue to grow and will be there in the background, a cushion when I fall down, and only a tiny drag if I do make it big. Since I’m still young and very much in the savings/accumulation phase of my investing career, my future contributions will be more than my current portfolio size, so even if I under-perform with my active portfolio (or even blow it up!) it won’t totally kill me, as long as I eventually put most of my assets into a passive portfolio that does work. Potato’s Valve should keep me investing in what has the best chance of giving me good returns in the future: my active portfolio if that continues to do well, or the passive if it doesn’t (assuming that active investing has any kind of chance — if it doesn’t, the valve will keep me from chasing that for very long with very much capital) while protecting me from myself.

Part of this comes back to what Michael James mentioned in the comments: an active investor has to pick a benchmark and compare how well they’re doing, and have some idea of what poor performance is. It makes no sense to spend the time doing active investing just to get a poorer result than you could get with a diversified passive portfolio, and not even know it! More to the point: if you can’t track your own past investment performance, what chance do you have of projecting the performance of companies in the future?

[Yes, this is the first time I’ve ever call that rule that, but I figure with a dumb name it might catch on]

4 Responses to “Active Investing – Potato’s Valve”

  1. Michael James Says:

    Your valve is an interesting system. One point I’d make is that to beat the market you have to be above average (by enough to cover costs) among active investors. It doesn’t matter how your investing skills stack up against passive investors or those who hand their money off to a professional money manager (e.g., a mutual fund). Whether you prove to be good enough to beat the market, at least you’ll know the difference because you’re one of the few who actually keep track.

  2. Canadian Capitalist Says:

    I’ve heard of something like this system before. It is a good idea when an investor wants to try her hand at stock picking.

    I used to pick stocks and also used to track the performance but let’s say you did outperform: is it luck or is it skill? In my years actively picking stocks, I outperformed my benchmark by a little bit but I concluded that it was luck. That’s because the stocks I had the most confidence in turned out to be total dogs and the stocks that I thought would provide slow-and-steady returns turned out to be barn burners. In a period when Canadian stocks were posting double-digit returns, my picks were lagging badly. In a period when US stocks in CAD produced modest returns, my picks were superstars.

  3. Potato Says:

    The luck element is a very tricky one to deal with. For example, though my absolute return was best in 2009, I consider 2010 to be my finest year since I had the greatest relative out-performance then. That was largely because I happened to be overweight REITs, and to a large extent that was luck (I happened to have an interest in them and considered them within my circle of competence, and they happened to give a lot of capital appreciation when they could have just as easily been ignored by the market while paying out their distributions). But even then, my REITs outperformed XRE by a healthy margin, and for now I’m chalking that part of it up to skill.

    Ultimately, it will take time to tell.

    To avoid deceiving myself, though I can chalk up wins to luck, I won’t do the same for misses. For example, it was just terrible luck that Sino-Forest happened to tank right after I bought it. But even before I bought I knew that I was stretching my circle of competence to buy it and hadn’t fully addressed the let’s say “corporate governance” issue. That was a mistake — if I couldn’t find anything to buy on the active side that I had confidence in, I should have just let the passive portfolio take that capital.

    Or, more to the point of Michael James’ recent post, even if I can (or fool myself into thinking I can) generate alpha, once I have a job it might not be worth my time to try to do so.

  4. wayfare Says:

    “…once I have a job it might not be worth my time to dry to do so.”

    That’s part of what keeps me passively investing I *could* spend a bunch of hours working on my portfolio in the hopes that I am somehow smarter or luckier than everyone else, or I could spend that time working for a guaranteed hourly wage.