
Active versus Passive investment strategies
The debate over the degree of efficiency of the markets has resulted
in the following investment strategies:
* Passive investment strategies suggested by efficient markets
* Active investment strategies suggested by inefficient markets
As an investor, you must decide on the degree of efficiency of the
markets to determine whether you should pursue a passive or active
investment strategy.
Passive Investment Strategy
A passive investment strategy involves the selection of diversified
securities in a portfolio that will not change over a long period and
is held over a long period. The securities in the portfolio are
changed only when a market variable, such as an index, changes
because passive investors believe that the markets are efficient
and that they cannot beat the markets over extended periods. By
investing in a mix of diversified securities, this type of investor
hopes to do as well as the market averages over long periods.
Passive investment strategies are achieved through buy-and-hold
investing and/or indexing.
Buy and Hold Strategy
A buy-and-hold investment strategy is a passive strategy based on
the premise of doing as well as the market by minimizing transaction
costs. No attempt is made to beat the market. By holding a broadly
diversified portfolio, which reduces the unsystematic risks (the risks
pertaining to the companies or the industries), investors should be
able to approximate the returns of the market. Stocks in the portfolio
are selected and held for the long term. Investors make few revisions
and make no attempt to time the markets. The success of this type of
strategy depends on the state of the market.
During an upward trend in the market, such as during the
decade of the 1990s, a buy-and-hold strategy would have benefited
most investors. Of course, in a market correction or crash, prices of
most stocks decline. Historically, however, after most stock market
declines, the markets typically have recovered and moved on to
greater heights.
In many conversations about the stock market, investors
recount how they were able to time the markets, selling their
portfolios days before the stock market crash and then moving
back into the market at a lower level. However, few investors like
to tell the story of how they exited the market in anticipation of
the crash that never materialized. This approach meant sitting on
the sidelines during a bull market and reentering the market at a
higher level.
The buy-and-hold strategy avoids the need to time the markets
or read the financial stock tables in the newspapers daily. With a
long time horizon, you have no need to time the markets because
you remain fully invested in stocks.
The second advantage of a buy-and-hold strategy is that
investors minimize their transaction costs. Similarly, they also avoid
the cost of acquiring information. This strategy does not mean that
they forget about the stocks they buy. In a buy-and-hold strategy,
investors still should review the performance of their stocks with
regard to growth in sales and earnings from time to time (year to
year) and get rid of stocks that do not present future potential
growth and earnings.
Indexing
The concept of indexing embodies the buy-and-hold strategy,
thereby minimizing the transaction costs inherent in a passive
investment strategy. By choosing a market index such as the S&P
500 or the DJIA and picking the same stocks as in that index for the
portfolio, an investor replicates the performance of the market
index. Individual investors may have difficulty replicating these
indexes because of the large numbers of stocks in the indexes (500
for the S&P 500) and hence the enormous dollar cost. Index mutual
funds and exchange-traded funds (ETFs), discussed in Chapters 14
and 15, make it easier to invest in all the stocks of the specific
indexes. In fact, index mutual funds have outperformed the many
actively managed mutual funds over the four-year period
1995–1999. Longer periods show a more compelling result:

Although the buy-and-hold strategy minimizes timing decisions
of when to buy and sell, investors still need to decide which
stocks to select. By approximating an index, the types of stocks
to choose become an easy matter. Deciding which index to follow
would depend on the investor’s overall objectives. A conservative
investor who is looking for income and capital preservation would
consider blue-chip stocks, utility stocks, and some of the more
established growth stocks. A more aggressive investor would
include growth stocks and the small-cap company stocks.
Investors who believe the market to be efficient would choose
stocks from various industries to form a diversified portfolio and
hope to replicate the performance of the market. According to the
efficient market hypothesis, investors could randomly select these
stocks because if the markets are efficient, these stocks are correctly
valued (at their intrinsic value). Efficient markets support passive
investment strategies; inefficient markets suggest actively managed
investment strategies.
Active Investment Strategy
An active investment strategy involves active trading of securities in
a portfolio in an attempt to produce superior risk-adjusted returns
to that of the market. Timing the market accurately always will
produce superior returns. Market timing is buying and selling
securities over short periods of time based on prices (patterns)
and value. This strategy involves buying stocks before their prices
increase. In other words, you would be fully invested in stocks in
an increasing market and out of stocks in a decreasing market.
Many newsletters advocate timing the markets. In timing the
markets, you have to be accurate in calling not only the top of the
market but also the bottom, and when to get back into the market.
The greatest disadvantage to timing is that little margin for
error exists in the accuracy of the timing of your calls on the market.
If you are correct 50 percent of the time, you earn less than
if you had a buy-and-hold strategy, according to a study done by
T. Rowe Price and Associates in 1987, as reported in Cheyney and
Moses (19). During the period from 1926 to 1983, investors who
were 100 percent accurate in their timing decisions would have
earned an average of 18.2 percent per year versus an 11.8 percent
average yearly return for a buy-and-hold strategy. With a 50 percent
accuracy rate in calling the market, the return was 8.1 percent.
Thus, to earn returns in excess of the market, investors would have
had to be more accurate than 70 percent of the time in calling the
market during this period (T. Rowe Price Associates, Inc., 1987, in
Cheyney and Moses, 1992). Table 12–5 highlights the lessons
learned from market timing.
Table 12-5
Lessons Learned from Market Timing
The falling stock market for the three-year period 2000–2002 showed disastrous
results for buy-and-hold investors. This situation prompted many brokerage firms
and institutional investors to advocate second-guessing the market through market
timing. These actions involved selling stocks for bonds and then, over short
periods, moving back into stocks from bonds. The condition for success for this
type of market-timing strategy is a volatile stock market that moves on a flat, sideways
trend. In a momentum-driven market where stocks are constantly going up
(1998–1999), a market timer would have underperformed a buy-and-hold investor
(Mattich, 2003). For example, the S&P 500 Index was up by 26.7 percent in 1998
and 19.5 percent in 1999, whereas one of the top market timers in 2000, Howard
Winell, lost 34 percent in 1998 and an additional 18 percent in 1999. In 2000,
which was the beginning of the bear market, investors following Winell’s advice in
his newsletter, Winell Report, would have earned a 46 percent return versus a
loss of 10.1 percent for the S&P 500 Index (Cropper, 2001).
Yet the results for market timers were not compelling for the year 2000. According
to Jim Schmidt of the Timer Digest, which follows the investment actions of 100
market-timer newsletters, only 65 percent beat the S&P average that year. This
number was less than the performance of mutual funds that beat the market that
year (Cropper, 2001).
Market timing is a high-risk strategy that is also expensive to maintain. According to
Mattich, William Sharpe, originator of the Sharpe index and the CAPM, found that
to break even in a portfolio that switched between stocks and bonds, you had to
be 70 percent accurate in your market-timing decisions to break even. Also,
increased transaction costs and higher taxes are involved with short-term capital
gains, which further erode any positive returns.
What are the lessons that can be learned with regard to market timing?
* Historically, stocks have risen over long periods, which means that every time
you exit the markets, you go against this long-term upward trend, indicating that
a buy-and-hold investment strategy will do better than market timing over long
periods.
* When you exit the stock market, you have to time the market correctly to get
back in at lower stock prices. If you do not time the market well, you go back in
at higher prices. Consequently, you should not exit the stock markets completely.
Keep some of your money in stocks, even if you lighten up on your stock
portfolio holdings.
* Diversify your stock portfolio holdings. Concentrating on one sector of the
market (technology, for example) has been a disaster. Recall the burst of the
technology bubble in 2000 and the astronomic rise and then precipitous fall of
initial public offerings (IPOs) during the period 1998–2000.
To paraphrase Professor Elroy Dimson of the London School of Economics, “Market
timing is a real mug’s game” (Mattich, 2003).
Technical analysis charts the past price movements of stocks
to time when to buy and sell stocks and advocates timing the overall
market and individual stocks. Fundamental analysis also advocates
timing but with a longer time horizon and a more critical eye
as to which stocks to buy and sell. Inefficient or weakly efficient
markets suggest that investors may be able to earn returns in
excess of the markets by pursuing active investment strategies. The
downside to timing the markets is that you may be on the sidelines
during an increasing market if you make a wrong call.
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