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.

What's Behind The Numbers - Intro

Every blow up avoided improves the performance of your portfolio.

Management faces crushing pressure to make things appear better than they are.

Management tortures the numbers to "beat by a penny" and to keep the Wall St analyst predators and their dreaded downgrades at bay.

Aggressive accounting may not be illegal, but its chicanery. Sooner or later, hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.

The job is to analyze earnings quality.

The book may place revenue recognition and inventory management next, but every part of the financials connects with another. "Earnings" is the financial picture as a whole.

Rising days sales outstanding or days sales in inventory may be the two great single indicators of trouble in the next quarter or several.

High Frequency Trading

The rationale for HFT is couched within the premise that we have a better idea of anticipating the near future than we do the far future. And there is evidence to support that contention.

HFT simply takes that principle (fractals) and reduces it to its logical conclusion (slicing time into its smallest pieces). For any quant pattern recognition/trend following system, the most critical control is downside risk management.

Bernstein on Forecasting

Bernstein wrote an editorial in the Spring 1996 Journal of Portfolio Management on forecasting that was a classic. Titled, "Fearless Forecasters, or Fearless Forecast Consumers."

After highlighting the ridiculousness of forecasting he drew the following conclusions:

(1) The question is not whether wildly wrong forecasts will happen, but what we do about the high probability that wildly wrong forecasts will happen.

(2) We should study expert forecasts as evidence of the state of expectations, but not as any kind of measure of what the future holds in store.

(3) We should concoct scenario forecasts because they force us to consider wide changes and even discontinuities.

(4) We should put more effort into managing risks and considering the consequences of being wrong.


He ends with, "pretending to believe that forecasts are going to be right may be the greatest risk of all."

There Is No Single Best Solution, But...

There is no single best investment strategy, approach, philosophy, solution. There is no unified theory of investment management.

For long term investing, there are however a few simple things you can do to increase the chance of positive outcomes.

Get on the right side of secular trends, ie. exposure to growth, increasing productivity, rising earnings/free cash flows. One important factor is the valuation level you enter at. Secondary factors are short-medium term momentum and longer term mean reversion facilitations.

Have a underlying philosophy that takes out some of the more common errors or mistakes, ie. thinking you can consistently time the market, choose the best manager, or make the right stock picks. Passive, low cost, equal weighted exposure to global growth factors.

Have the humility to realize that you don't know it all and that you won't always get it right, therefore have a disciplined downside risk management framework that either includes strict stop loss limits and/or non-correlated asymmetric downside protection.