Investment style and strategies have certainly become very complex these days. We’re in a unique period of time with the evolution of the global financial markets, complex investing strategies, thousands of funds, derivatives and other financial instruments to choose from. It can be down-right scary for a new investor to get started. There are hundreds of opinions and strategies that you can find on the internet to help you get started. But which of these is the best fit for your investing style and risk tolerance? More importantly, which one is the best to help you meet your goals?
Do you know what YOUR investment style is? That can be a difficult question to answer. Today’s financial jargon uses terms like ‘passive investor’ and ‘active investor’ and there is all the hybrid investing styles in between. To understand what those mean and where you fit in can require a lot of research on your part. I thought it would be interesting and fun to take a historical perspective and see where these terms came from. Sometimes knowing the history can be the foundation upon which you make your decisions on how to move forward.
There are two classic views to consider. One of the most classic books on investing style is “The Intelligent Investor” by Benjamin Graham. It has stood the test of time and has mentored many a great investor. It is thought by many that Warren Buffett was a protégé of Benjamin Graham.
Investing Style According to Benjamin Graham
Originally written in 1949, Graham’s views on investment styles has stood for a very long time. There is something to be said for his theories that have stuck around for that long and still debated today. A key takeaway from the book is Graham’s view of two investing styles or categories:
The defensive investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his skill and effort, in the form of a better average return than that realized by the passive investor. – The Intelligent Investor
One of the resulting positions of Graham and his followers is that through technical and fundamental analysis, an “enterprising” style of investor can do better than the market. It’s not the intention here to dive into the details of what technical analysis is or what fundamental analysis is. But basically, technical analysis is the study of the market movements and is used by some analysts to ‘time the market.’ Fundamental analysis is used by some analysts to dive deeper into specific companies by analyzing their financial statements and looking for growth or value attributes.
By following this investment style, an investor would then be able to, in theory, predict winning stocks that would be the market indexes. In modern-day language, we would refer to Graham’s “enterprising” style as one of “active” investing, requiring a significant amount of knowledge, time and effort to perform the analyses required.
Alternative Investment Style According to the Efficient Market Hypothesis
An alternative view is based on the Efficient Market Hypothesis (EMH) theory developed by Eugene Fama in his multiple writings and thesis beginning in 1965. Again, without getting too technical, the most concise definition of EMH that I could find comes from Investopedia:
The efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments. – Investopedia
If you follow this theory, you should be able to invest in the various stock market index funds such as the S&P 500 and track your returns to the return of the index. That can be very good when you are investing over the long term because, generally, the S&P index performs very well in the long term. But it may not be the best solution for short-term investors. And it may not be the best solution IF you can find an actively managed fund that consistently outperforms the index. The key word being consistent.
Studies have shown that it is becoming increasingly difficult for a wealth manager, fund manager, or any finance professional to consistently outperform the market. These studies indicate that such professionals can only beat the market about 1/3 of the time. In other words, about 1 year of every 3 years. There just aren’t any Peter Lynch’s around anymore that have his track record over the long term.
Even Warren Buffet has made a case for how defensive (or passive) investment style can play a key role in certain situations. As he states in his letter to shareholders in 2014, he instructs the trustee of his will, for his wife’s benefit, that “the goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that.”
So in the case of these two investment styles, you can see the very powerful strategy to be ‘enterprising’ or ‘active’ that may have worked in the past, but as the market gotten far more complex and efficient, there’s a compelling case to consider the ‘defensive’ or ‘passive’ investing style.
Which one is right for you depends on many circumstances. Are you knowledgeable enough to perform the technical and fundamental analysis on your own? Do you have the time? What is your wealth manager or fund manager’s track record over the long term? Do you know the right questions to ask or where to get educated?
In the next blog article, we’ll explore a little deeper about what things you should consider to determine whether you should be active or passive in your investing.
Actions You Can Take
Start by writing down your overall purpose in life, the specific goals you would like to achieve (short, medium and long-term), and the risk you are willing to take (how much you are willing to lose). Make an attempt to create a personalized Investment Policy Statement for yourself. Then seek out a qualified professional to help you come up with your personalized financial plan and investment style that is best for you.
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