Active Management - Don't Just Stand There, Do Something...Not!

Active management is predicated on the odds of making a good directional call, the conditional magnitude of the expected change in the markets, the proper sizing of the change in the portfolio to take advantage of that information edge and the timing of entry and exit from the portfolio repositioning.

Anytime the odds are against you, you should not be making any portfolio changes. There are times when the odds are in your favor, but the magnitude of the expected market change is not great enough to warrant changing portfolio position.  And there are times when the odds are in your favor, and the expected market change is sufficiently great to warrant altering portfolio position to take advantage of the potential opportunity. When that is the case, it is critical to stick the entry and exit.

Three things must be got right to benefit:

1. You must have some idea of the odds wrt market directionality (because you are dealing with the future, odds are entirely subjective...now you may have all sorts of historic-based or fancy forecasting models, but you need to also allow that the odds you perceive are out of whack). Odds are focused on market directionality and magnitude of market move. If you bet and get directionality wrong you are toast.
2. Odds on market directionality is hard enough to get right. But gauging the second leg of good active management calls, ie. magnitude of market move (assuming you got directionality right) is another crapshoot. Once again active managers have all sorts of tools, charts, and fancy models to help, but it is all guesswork. If you get the second leg of a good active call wrong, ie. the proportions of the market move, then you risk having made a portfolio change for only marginal gain, ie. limited benefit, and have incurred unnecessary transaction costs.
3. Assuming you are right about the directionality and the magnitude of a market move, you then need to get three additional elements right. The timing of repositioning the portfolio, the sizing of the repositioning to take advantage of your insights, and the timing of your exit from that position (which requires a whole new set of odds related to directionality and magnitude). This may in fact be the hardest part of portfolio management.*

Active management is tough. There are a lot of moving pieces and a lot of unknowns. You've got to get a lot right to gain from your insight.

* A recent study reported on in the latest AAII magazine pointed out the ability of stock pickers to pick stocks is pretty good. But they stink at all the other elements of portfolio management.