It’s not Active vs Passive

This isn’t yet another debate about which is better in the long run. This is a discussion on how passive investing complements active investing.

Learning lessons the hard way

I have a solid history of picking trades that represent good value but in the first half of my investing career I didn’t have a good history of letting those trades run. I was always afraid of large drops in price. Eventually this taught me several things:

  1. An equity-only portfolio was a bad idea for me.
  2. My position sizes were too large. I got out too soon if they went against me.
  3. I had something, whether it was a worldview or analytical skill, which allowed me to find good values.

I squandered #3 because of #1 and #2.

Traders will hear that they should cut their losers fast and let their winners run. The reality is that the capital markets are really random. Why sell something just because an unrelated risk caused mark-to-market losses of 20 percent? The argument of course is that a trader is wrong on his thesis and the only thing that pays is price.

But if you look at history, the people who make the most are those who own good assets and hold them for really long periods of time in spite of huge price swings.

So how did I rectify those particular errors?

Smaller position sizes. It’s rare for any single company to be greater than two percent of my portfolio. That way if the position tanks 50 percent my portfolio has only dropped one percent. I can make the decision as to whether the market has lost its mind or if I missed something major and either cut my losses or average down as appropriate.

Two percent position sizes!?! But I’ll need 20 to 40 ideas to fill out my equity sleeve!

That math checks out. Personally I’ve never had more than a half-dozen or so good ideas at a time. It’s an acknowledgement that I don’t have adequate domain expertise or insight to know whether the market is truly mispricing something or not. Saying “I don’t know” is a surprisingly powerful risk management tool.

It’s notĀ Active vs PassiveĀ but Active & Passive

The active vs passive debate misses the point. How many good ideas do you have where you have enough expertise or insight into a situation and can accurately say that the market has mispriced a security? For most investors those situations are limited.

So what do you do with the rest of the asset sleeve when you still need exposure but only have two good ideas?

Go passive until you find your next idea.

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