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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