(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty of highly competent, ethical professionals out there who are excited to help you achieve your goals.)
After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.
So back to this active versus passive investing thing. It sounds like you are pro passive?
If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.
Ugh. There you go again. But how can I figure out if I’m good at investing actively?
We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.
Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.
You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.
There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.
If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.
Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.
That seems complicated and unhelpful.
Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).
Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?
There is no Best Thing To Do. There is only The Best Thing For You To Do.
So what does YOUR portfolio look like, big shot?
Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.
How do you know these managers will perform well over time?
I don’t. Honestly, just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.
Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?
Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.
Risk management, remember?