by | Sep 17, 2009 | Miscellaneous | 0 comments

Benefits of Active Management

Active management keeps the math of losing from eating at your portfolio

The reason the math of losing is so powerful is that if you begin with $1.00 and lose 50 percent (50 cents) you only have 50 cents left. To earn 50 cents on 50 cents requires a 100% gain – to overcome the 50% loss.

Active management is really a risk reduction tool. By using tools to help avoid the largest losses, future gains become easier to make. So, although investment gains are our secondary goal after risk avoidance, larger gains are often the result of effective risk control.

As the illustration says, defense wins in investing, just like football. Every investment needs a defensive element or . . .

Active management can work in both up and down markets

Buy and Hold works well – but only half the time.

When buy and hold is working it can work very well, but it only works about half of the time. The other half of the time it can be a disaster–as investors in 2002 or 2008 found out.

A Hepburn Capital study shows that from 1950 through 2007 the S&P 500 Index rose 50.6% of the days the market was open, fell 49% of the days and was unchanged .4% of the days.

Because the effect of losses on your account values are much greater than the effect of gains (as the Math of Losing shows), it is critical to your success as an investor to reduce losses. However, buy and hold does nothing to reduce losses.

Active management can make money for you in up markets and defend your account values in down markets.

Active Managers must have greater skill

What we do at HCM is not easy.

Anyone who has played poker knows that three of a kind beats a pair. However to play poker and win over long periods takes a whole different level of skill and experience. A successful active manager brings a whole new level of skill to the table–skills not found in brokers and ordinary buy-and-hold oriented advisers.

If your adviser says, “no one can anticipate market declines well enough to avoid them,” what they really mean is that they can’t. HCM’s proven record of avoiding the majority of losses in bear markets is proof that it can be done and that we have the skills to do it.

Active management provides true diversification

Buy and hold investors are often diversified at two different levels: Diversification among asset classes such as stocks and bonds, and then diversification within those classes such as not owning one stock, owning many.

However, there is a third level of diversification: by strategy. Investors can have different ways to tell when to sell and when to buy.

Ordinary investment advisers overlook this third level of diversification, and as a result, most investors who took large losses in the bear markets of 2002 and 2008 had only one strategy, buy and hold – with no exit strategy in case things quit working as planned.

At HCM, we believe that every investor should have at least a portion of their portfolio allocated to active management or they have a lack of diversification.

Diversification is widely considered one of the best risk reducing tools available to investors. So, if diversification means safety, it makes sense that adding strategic diversification can bring added safety to a portfolio.

Active strategies can Adapt to Changing Markets®

Rarely does an investor buy a bad investment. Almost all start out as good investments because they are in sync with the then-current market.

But markets always change. What happens to your investment when market forces change? Can a buy and hold investment adapt? No. By definition it will not change, even in the face of a failing market.

It takes an active strategy to Adapt to Changing Markets®.

Wall Street encourages Buy and HoldOrigami_Buy_and_Hold

Wall Street creates new issues of stocks, bonds and mutual funds, and Wall Street must sell each new share to some investor. If they are the only sellers then their job is easy and they get rich.

They have developed a highly polished sales machine to encourage buy and hold investing. Your money is the raw material of Wall Street’s profits. The worst thing you can do to them is to sell and take your money out of the stock market. Yet, that is what the managers at HCM do from time to time, because we work for you not for them.

The Brinson Study

The mutual fund industry often quotes a study (Brinson, Beebower and Hood, 1991) telling investors that 92% of investment success is determined by your asset allocation decision – how much you have in stocks or bonds or cash – and only 8% of your success is determined by market timing and actual security selection.

A mutual fund salesperson would have you just pick some investments, never change them, and leave the little 8% part to the pros that manage the mutual funds. Buy and hold. Sound familiar?

However, the Brinson study never suggests that you can’t change your asset allocation in the face of a weak market. Our interpretation of this stucy suggests that if 92% of your gains come from being in the right category and 92% of your losses come from being in the wrong category it makes a lot of sense to move your money out of the weaker and into the stronger categories as the markets change. We seek to avoid losses and garner better gains.

The easiest way to make money

We have found that the easiest way to make money is to have more in investments that are going up and less in investments that are going down.

This is a simple concept, but it is not easy to actually do.

Since all big losses start out as small losses, at HCM we have systems to tell us when it is time to move out of weakening investments to avoid potentially devastating losses. And, we have other systems to tell us when and what to buy.

By repeating this simple cycle, over and over, we help keep our clients on the path to growth.

Individuals can’t hold forever

The studies that show long term returns from the stock markets are often run over very long terms, often over 60-80 years. Yet most investors don’t have that much time, and need to plan an exit strategy.

Buy and hold gives you no exit strategy. You will be at the mercy of the market when you need or want to sell.

Active Management vs Buy-and-HopeCash can be king

There are times in the market when the only thing going up (or not going down) is cash.

Successful investors need a way to recognize those times and a strategy to protect their savings by moving into cash during prolonged market declines.

Buy and hold is not a strategy to protect anything. Buy and hold is the lack of a strategy!

Systems can reduce the emotions inherent in investment decisions

Investors who fail, often do so because they plan to hold on to their investment through thick and thin, but end up not being able to handle the grinding emotion of seeing losses mount up month after month and decide to sell too late – usually near the bottom.

A strategy that is thought out in advance – at what point will you admit that “it just isn’t working out” and sell – can save the deep losses that emotional decisions often create.

Greater Risk Adjusted Returns

Which way would you rather have your investment adviser work? By rolling dice in Las Vegas–double or nothing–or by accepting a lower return while avoiding the potential for devastating losses?

This concept is at the heart of risk adjusted returns. Reducing risk has value. Active management is primarily a risk reduction tool.

At HCM, we believe that keeping losses small means more of your capital remains intact, leading to larger gains when the markets turn back up.

B&H bears full risk of market declinemarket-crash

Most investors do not understand that when they embark upon a buy and hold investment, that they assume the full risk of a potential market decline.

Nobel prize winning economist Paul Samuelson once said, “The longer one invests the more like they are to experience a catastrophic market event. Risk does not go down with time, it goes up.”

I would add that risk goes up if you stubbornly stay invested as the markets collapse.

Active management can deliver benefits that few mutual funds can

Investors buy mutual funds to get professional management. Yet most mutual fund managers are very limited in what they can do by restrictions in their prospectus.

Does your prospectus say something like “the portfolio will be at least 80% invested in growth stocks”? That’s great if growth stocks are performing. What if they aren’t?

Even if your fund manager sees a runaway freight train coming in the market, he cannot legally get 80% of your money off of the tracks. And the majority of mutual funds have restrictions similar to this example.

Although we don’t trade very frequently at HCM, we have the ability to move our clients 100% to cash – and out of the way of crashing markets – in a matter of minutes if needed.

Buy Low, Sell High has two parts

Just about every investor has heard of the great American investment creed, “buy low, sell high”, but few think about it as having two parts. It does.

Buy and hold totally ignores the second half of the creed making investment failure more likely while active management embraces sell strategies.

Buy and Hold advisers may not be any help when markets crash

As sincere as most buy and hold advisers are in telling clients, “I’ll watch the investments for you,” all they can do is watch.

Businesses structured to sell buy and hold investments cannot efficiently support an actively managed portfolio. Often all a buy and hold adviser can do is helplessly stand by and watch as a market crash unfolds.

Their brokerage firms often will not let them move you out of an investment you have paid a commission to get into for fear of being accused of “churning” commissions. If you are in a commissioned investment, this should be a warning flag for you.

Ordinary advisers are set up to deal with one investment for one client at a time. They are required to speak individually with each client before moving some or all of their portfolio to cash.

How long would it take to speak to 100 clients? To review your file, make the call, say “Hi, how are you? And the kids? By the way, the market is acting funny – no I’m not certain – but I think you really ought to consider moving your account to cash.” Perhaps make follow up calls after the client has thought about it since few like to make snap decisions about money, make notes after the calls, and then execute your one trade?

It could take weeks for an ordinary adviser to move all of their clients out of one investment and weeks to move back in. They just aren’t set up to do that kind of work.

AT HCM, we can move 100% of our managed accounts to cash in a matter of minutes if needed. We have designed our whole business to be ready for that one critical moment when action is needed to preserve your portfolio values.

Advisers who advocate buy and hold do so because it is easy. For them.

Benefits of Buy and Hold

Buy and Hold is cheaper

It is true that buy and hold may cost less up front to implement than maintain an active strategy over time.

But at what cost do those savings come during a market downturn? HCM’s Careful Growth Strategies out outperformed the S&P 500** during the two recent bear markets by enough to earn back 10, 15 or 20 years of fees in one year.

Cost is what you pay. Value is what you receive. We believe active management delivers the best value for today’s investors.

Do you really want your financial security to rest with the lowest bidder?

Buy and Hold is easy to understand

We all tend to shy away from things we don’t understand, and few investors understand how to execute an active strategy well enough to be comfortable doing it, so finding buy and hold attractive in its simplicity is a natural tendency .

If easy is what you want, without regard to results, then buy and hold may be for you.

However, at Hepburn Capital, we make the active management decisions for you so you don’t have to try to master the complexities of the business.

no-effortBuy and hold takes little effort to implement

What’s not to like about making one decision and being done, maybe set for life? That is an appealing proposition to most of us and makes it an easy sell for financial advisers.

But life is rarely that simple. What if something stops working?

At HCM, we can make active management as easy for you to implement as buy and hold. All it takes is one decision.

Reduces manager error

All investing has the potential for manager error at some level. Whenever an active manager makes a decision, whether to reduce market exposure or increase it, there is the potential to be wrong. This is called manager error.

But buy and hold also has potential for manager error. What if your adviser recommends a mutual fund and you realize after a crash that the fund manager had a policy to stay fully invested at all times which meant you took big losses as you rode the market all the way to the bottom. That could be construed as manager error on the part of your adviser.

Buying with no exit strategy is also a form of manager error.

Buy and hold works well in rising markets

Buy and hold is a great strategy as long as markets are going up.

This is why we refer to HCM’s style of management as modified buy and hold. As long as the investment is going up, we hold it. If it begins to go down, we sell it. It is simple concept that just needs careful monitoring.

At HCM, we will analyze every investment we own in your account every day to determine if it is going up, down or sideways and take appropriate action.

Buy and hold reduces contact with brokers

Brokers and financial planners who are aggressive sellers of investments can make their clients uncomfortable at times. How do you know whether the investment being touted is really right for you or just another commission for the adviser? Usually you don’t.

If investments are bought with the intention of never selling, contact with pesky mutual fund and annuity sellers can be avoided after the initial investment is made.

At HCM, we take no commissions. Our only motivation is to make your account grow as our fee will increase with the size of your account. This best aligns your interests with ours, effectively eliminating the conflicts of interest associated with commissioned sales.