Markowitz and the barfly

Everybody knows one of those inveterate gamblers who’s always at the pub crowing about the latest long-shot bet that netted him a fortune. You never hear him mention all the punts that failed.

There are many parallels with investing here. Many people think that great investors are the ones that spot the great enterprises early, buying the shares that jump 10-fold. However, I believe that avoiding the torpedoes – Enron, Nokia, RBS and Kodak – has a much greater influence on returns. Losing a significant portion of your capital in one or two stocks, even over a period of years, can have a tremendously negative impact on your returns, even if you do find one or two others that soar.

I believe the really great managers are those that play the percentages; that weigh risk and return to get a bargain. And the best gamblers are usually the ones that you never notice, too. They are the ones that stick to their strategy and their expertise to achieve steady wins. It’s much less glamorous, but then most hard work is.

This is the foundation of why I am an unabashed advocate of active management. When done well, I believe it offers better results for investors. And this is most true in multi-asset investing, where managers have the ability to diversify across asset classes and free themselves from the idea of relative return (more on this in a coming blog). Through the magic of modern portfolio theory, diversification really does offer better returns for lower risk. By spreading jeopardy and monitoring the correlation of your assets, you can offer value that a passive approach simply cannot deliver.

Passive investments have been booming lately, but I worry that many people have been piling into them during a period of rising asset prices. Almost across the board, equities, bonds and property have soared over the past eight years. In an environment like that, it makes sense to take cheap beta, or market risk. It means you got more of the upside and didn’t have to pay much away in fees.

But rising tides in asset markets, like we’ve seen over the past few years, typically hide the torpedoes. When economies get a little rocky or monetary policy tightens, that’s when they blow up. I worry that a market wobble could harm many investors who are holding index-trackers and don’t realise that passives are pure market risk – no more, no less. They have a beta of one and no way to change it, which means there’s nowhere to hide on the downside and no way to dodge the torpedoes.

In a few years, there may be fewer people leaning on the bar bragging about how well their S&P 500 ETF has done. I hope not, but I worry.

David has written a report exploring how active managers can reclaim the high ground in asset management and why active investing may be better suited to the challenges of the years ahead.

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