INVESTMENT SERVICES - Why Active Management Makes a Difference

 

There are three basic approaches to investing.

A buy-and-hold, or unmanaged portfolio allocates assets to targeted investments and then stays with those positions regardless of market conditions.  When the market rises, this investment approach typically moves up as quickly as the market, but it experiences the full pain of the market when it turns down. As a result, buy-and-hold investing can be one of the riskiest approaches to investing.

It’s important to realize that when the market is down 30%, it doesn’t take a 30% gain to return to breakeven. It takes a 43% gain.  Historically, buy-and-hold investors on average spend 66% of their time losing value to down markets and then returning to breakeven. That’s leaves only 33% of the time invested to actually make money.

There can also be no guarantee that an investment will ever recover its former value. Many technology stocks are still 75% under their stock prices in early 2000 and analysts question the ability of some companies to ever recover.

 

Classic asset allocation attempts to reduce the risk of investing by allocating a portfolio across assets or asset classes that typically move in opposite directions and maintaining those allocations regardless of the market’s direction. For example, when bonds are gaining value, stocks are typically in a decline. By diversifying to include both stocks and bonds, asset allocation tries to assure that part of the portfolio is always increasing in value. 

A primary limitation of this approach is that the portfolio as a whole will virtually always under-perform the market indices. Asset classes also do not always stay uncorrelated. Passive asset allocation can fail to limit losses in major bear markets and does not easily adapt to opportunities or changes in the market.

 

Active asset allocation as an investment approach can respond to market conditions to preserve capital in market downturns and invest opportunistically. While there is no “perfect” active strategy and all active approaches have the opportunity for loss as well as profit, taking an active approach to investing is the only strategy that allows an investor to capitalize on profit opportunities throughout the market cycle.

Active management allows an investor to:

  • Preserve principal in down markets by moving to a cash position
  • Adjust a portfolio’s exposure to the financial market in response to the perceived risk of the market
  • Invest opportunistically in rising segments of the market while avoiding those losing value or showing little current potential for gain.

Opponents of active management will often maintain that no one has ever predicted the market consistently, thus there is no point in trying. This argument fails to take into account the mathematics of gains and losses. Active management does not need to be perfect to outperform market benchmarks, it just needs to be right more often than it is wrong.

Tools to reduce risk proliferate in other areas of our lives, from insurance to maintaining a healthy lifestyle. It only makes sense to manage risk in our investment portfolios as well.