Ask Money

The hazards of active trading

Chris Farrell May 4, 2012

Question: If watched closely, is it wise to jump between aggressive stock funds and bond funds during market runs such as the bull run so far this year? The year-to-date return is 18 percent for my strategy. My Fidelity account has rules regarding moving between funds, so I have to navigate those rules also. Marty, Cincinnati, OH

Answer: I don’t think it’s wise or a good use of your time. You’ve done well with the strategy so far, but for how long? I don’t think it’s realistic to assume you’ll consistently beat the market (and evade the Fidelity trading restrictions).

I recently came across this statement from Howard Marks, the highly respected chairman of Oaktree Capital Management:

It would be great if we could predict what economies and markets will do, move in and out with perfect timing, foresee which industries and companies will fare best, and hold only the securities with the highest returns. But to paraphrase John Kenneth Galbraith on forecasters, I feel there are two kinds of investment managers: those who can’t do these things and those who don’t know they can’t do these things.

What’s true for the professionals also holds for individuals — with good reason. Investing is the most competitive business in the world.

Astronomical sums change hands every day around the globe as millions and millions of smart investors (and many more not so smart ones) try to get an edge on the competition. Many of these professional investors employ powerful supercomputers, quicksilver communication networks, sophisticated algorithms, and legions of highly experienced traders.

I’m in the camp that believes the best use of your time and strategy is to keep it simple: Diversify, dollar-cost average, rebalance your portfolio as you age, invest prudently to limit downside risk, and keep fees really low. Forget trying to beat the market. Instead, focus on what you’re trying to accomplish with the savings and match your investment strategy to those goals. Broad-based, low-cost index funds are ideal for this investment strategy. It’s a practical approach for a 401(k) generation that is not only trying to save for retirement, but also do a good job at work, maintain relationships, volunteer in the community, have some fun and so on.

That said, in one important sense, individuals who want to invest (not trade) have an advantage over the professionals. You’re investing for yourself. You’re the client.

An inherent problem in the money-management business is that professionals are managing other people’s money. Clients leave if they underperform the market. Professionals understandably want to stay employed. The easiest way to limit their career risk is to invest with the crowd. A pro can lose her job being wrong on her own and keep it by being wrong along with everyone else. Individuals can afford to wait.

Jeremy Grantham, the legendary value manager at the money management firm GMO, writes about the flaws in the investment business in his latest newsletter. Grantham has three key recommendations for individual investors who want to profit from this market inefficiency:

First, you must allow a generous Ben Graham-like “margin of safety” and wait for a real outlier before you make a big bet. Second, you must try to stay reasonably diversified. Third, you must never use leverage.

His advice is wise.

I would add a couple of additional thoughts. Your investment idea should have a 3- to 5-year timeframe — short enough to be realistic and long enough to steer clear of market fades and emotions. It’s a satellite investment to your core strategy. You want to expose your portfolio enough to your idea that you can enjoy a nice payoff if you’re right yet not so much that your portfolio is at risk if your idea turns out to be a dud. Typically, making a bet of less than 10 percent of your overall portfolio passes the prudence test. It’s big enough to count but not large enough to be disastrous.

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