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Active versus passive investing

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DavidV

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I have a question: how active should non-professional investors be? In other words, to what extent, if any, is it possible to beat the market?

To expound on the question some more: As I see it, I can invest in indexes for the long term, I can try to time market moves in the short run, or I can pick individual stocks for short-term opportunities or long-term growth. However, is it possible for individuals to beat the "wisdom" of the markets? Under what contexts? Wouldn't the nature of the markets nullify any strategy that relies on non-industry specific knowledge?

Random thought: the only way I can think of gaining an edge in the markets is to take advantage of other investor's irrationality - that is, to profit from a "buy high, sell low" emotion-driven strategy of other investors. Yet even this strategy is surely preempted by the markets as well.

Edited by GreedyCapitalist
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However, is it possible for individuals to beat the "wisdom" of the markets? Under what contexts? Wouldn't the nature of the markets nullify any strategy that relies on non-industry specific knowledge?

Random thought: the only way I can think of gaining an edge in the markets is to take advantage of other investor's irrationality - that is, to profit from a "buy high, sell low" emotion-driven strategy of other investors.

When the driving force behind profit vs. loss is predominantly irrational, your profit would come from early recognition of changing trends in rationality. For example, the banking mess was the predictable result of high-risk loan-making practices, and the chickens had to come home to roost at some point. As an individual you needed to know about these practices (many people didn't), and you had to understand the extent of these practices. Then you needed to know when that last straw had probably been added to the camel's back.

I think the relevant distinction is knowledgeable versus non-knowledgeable investors (which then presumably though not necessarily puts professional investors in the former category). Knowledge includes knowledge of the irrational behavior of other investors, such as the wild swings that accompany any announcements of "god news" versus "bad news" -- even when the news doesn't relate to the stock in question.

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Is it possible for individuals to beat the "wisdom" of the markets? Under what contexts? Wouldn't the nature of the markets nullify any strategy that relies on non-industry specific knowledge?
I wouldn't exactly call it taking advantage of others' irrationality, but IMO the best way to beat the market is to simply invest with a longer term outlook than that of marketeers.

Suppose the bigwigs are urging people to sell stock X right now, because they believe it's going to underperform over the next 2 years. If you can see that it will outperform the market over, say, the next 5 to 10 years, you'll come out ahead eventually.

The masters of the markets aren't nullifying a strategy that's beyond their outlook.

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First, throw away the notion that markets are rational. That is totally unfounded and completely wrong. The finance theories that they teach in universities are garbage. Factually speaking, the opposite is true: financial markets are highly irrational.

For the nonprofessional investor who wants to spend a few hours a week doing homework, the best advice is to follow the wisdom of Buffet and his mentor Graham. That is, buy good companies with solid, reliable, and understandable business models for cheap prices and hold them. What does that mean? For instance, it is likely that Coke will still exist in 20 years, and that people will still drink Coke. It is likely that most of those who are yet to be born in the next 20 years will also drink Coke in the future. Given the strength of its brand, KO is a great stock to own over the long-term (it also has a long history of dividend payments). The real question is when should you buy it. Typically when everyone else wants to sell; that way, you will be able to buy it at a cheap price. When the market is down, think of it like a sale at WalMart--an opportunity to buy things cheaper. Like right now. It's a great time to buy companies on the cheap!

Edited by adrock3215
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First, throw away the notion that markets are rational. That is totally unfounded and completely wrong. The finance theories that they teach in universities are garbage. Factually speaking, the opposite is true: financial markets are highly irrational.

Sure, there are times when an individual company's stock price becomes irrationally depressed, but to call financial markets "highly irrational" is a little dramatic.

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When the driving force behind profit vs. loss is predominantly irrational, your profit would come from early recognition of changing trends in rationality. For example, the banking mess was the predictable result of high-risk loan-making practices, and the chickens had to come home to roost at some point.
Funnily enough, many money managers who were bearish did not do too well in the recent downturn. Part of the reason may be "being early". Even if we assume irrationality, it is hard to tell how long such irrationality will continue and perhaps even get fresh help from the government. Apart from the problem of timing, there is the problem of choosing the right alternative. For instance, many libertarian-leaning managers have been predicting the short-market bust, but pushing people toward oil and other commodities -- and these alternatives have plummeted too. Another (non-Libertarian) who faced a similar result was Jeremy Grantham, who runs a huge fund. He has been predicting the fall of the U.S. economy for a while, but he thought foreign stocks would be a place to hide, which turned out to be untrue.
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Sure, there are times when an individual company's stock price becomes irrationally depressed, but to call financial markets "highly irrational" is a little dramatic.

I don't think it is. Have you ever been to an auto or an art auction? Multiplying the number of buyers and sellers doesn't make the process any more rational.

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