August 16, 2007

Passive v/s Active investing

There is an interesting post by prem sagar on passive v/s active interesting. In response to the post deepak has posted a response on his blog

If I have understand it correctly, prem’s position is that one should calculate the delta returns one would get by investing actively and compare it with other sources of income such as a job and decide if it is worth the effort. For ex: an extra 3-4 % return on a portfolio of 10 lacs could mean 30-40 K extra money. Not enough to make active investing worth your while.

In contrast deepak’s position is that if the returns are around 50% then the delta would be 3-4 lacs (for a 10 lac portfolio). With these kind of returns, active investing can be looked at seriously.

I have thought long and hard on this above issue. My take is as follows

I think prem’s position is perfectly valid for a new investor. I really doubt if it is possible to earn 50% annual returns for a long period of time (atleast 5 years or more) by spending 1-2 hours per day on the side. However if you are one of those guys (I am definitely not) who has earned 50% per annum (from 2001-2006, which covers a bear and bull market) then you are an exceptional investor. If I were you, I would seriously look at investing as a career. I would get my returns audited (no one is going to believe unaudited claims) and then look at the publicizing the returns. For a person capable of earnings such returns, attracting capital would not be diffcult. One can start an investment partnership and become really rich.

However I am definitely not such a guy. My final objective is to reach that level referred to by deepak. So what I do in the interimn?

This is my thought process (which mirrors prem’s approach partly)

a. save money and increase the amount of investible capital
b. learn and improve my skills to improve my returns
c. When the investible capital becomes high and my returns (for atleast 5 years rolling) cross a threshold, it maybe time to look at investing as profession (assuming you love to do this, I do)
For ex: passive investing returns are 15% (long term index returns). Active investing returns are say 30%.Investible capital is say 100 lacs. Then a net extra return of 15 lacs may be worth the effort.

BTW, to give you an idea of what 30% long term returns mean, consider the following – superinvestor ‘warren buffett’ has made 26% per annum for last 50 years, george soros has made 30-35% per annum (may be a bit more) for around 30 years and rakesh jhunjunwala around 70% (assuming he started with 5000 rs and has 4000 crs or 1 bn dollars now). So if you can make 30%+ for more than 10 years, you are an exceptional investor and can really do well.

For lesser mortals (it is easy to think that you are exceptional based on 1-2 years returns, I did that myself in 1999-2000), I think prem sagar’s approach is a valid one to start with, learn as you go along and deepak’s is the one to aspire for.

As an aside, I completely agree with deepak’s concept of leverage which is also referred to by several other
authors.

5 comments:

Deepak Shenoy said...

Thanks for the comments, Rohit - One of the key things to note here is that if you spend more time understanding the markets now, you will eventually get to a stage where managing your investments will take very little of your time and yet create enormous wealth.

Even I hope to be that way. I have only managed a sub-50% return myself (33% or so) over the last three years on a compounded/value-added method. But I have barely been active!

50% over a long term is usually difficult as you said, but there are those (like John Arnold) who have done that continuously over the last five years. What I would say is that there are enough opportunities to make a huge difference to your returns if you actively managed them (versus giving them to mutual funds) - in your specific case, I think you would probably be a better manager of your money than a mutual fund :)

Rohit Chauhan said...

i agree with your comments, but have had the following doubts ..these are personal doubts which only i can answer for myself , but i guess they are valid for everyone

- how do i know that my recent performance is due to ability and not luck. i may be on a lucky streak : i would say that this can be answered only if i have beaten the index for a reasonable amount of time (5 years or more)

- confidence to manage my funds completely v/s partly (via mutual funds). It is one thing to invest 30-40% of assets on your own v/s all 100% on your own. If i am just starting out (in early 20's) then i would have done that. but if i have a family to take care of ,then i cannot afford to risk their future till i am confident. basically my level of risk tolerance.

i have been investing for almost 8 years now and have had an average return of around 30% per annum. So my level of comfort is much higher now. however i would not have taken this level of risk back when i was just starting out.

i guess my low level of risk tolerance is why i am not an entreprenuer like you :)

Prem Sagar said...

Hi Rohit and Deepak,
25% + return year-on-year is difficult for anyone!! For every celebrity investor who gets talked about, there are several who fail to even beat the market!!

My contention is this
1. what is the delta return
2. is it high enough given the time spent for it? Give a leeway to yourself and extrapolate it a few years from now when you might have higher capital.
3. Can you somehow better that performance in other ways that excite you more?
4. is your active involvement a hindrance to anything that you do?

My answers to the above is
1. delta inconsistent and not high
2. finance excites me. But so many other things excite me too. I want to explore them, if possible.
3. I think I have other avenues to make as much and I am excited to explore them! As of now, it is my career.
4. My career is going great guns now...from that standpoint my active involvement in market is a dampener!

So my idea is to
1. Focus on increasing income.
2. Save more.
3. Keep expenses steady/ maintain discipline.
4. Invest your money with respect to time spent. This should not divert you from step 1. First thing is to get the coffer filled!!
4. Build a strong base. A house, some safe investments, basic covers, etc. These should shield you in case of any mishaps.
5. Once your base is set, prepare for a nitrous-boost-move. A risky venture/ a high risk reward venture/ whatever that excites you. I dont know what that would be in my case. You can afford to fail in this as many times, because your base is set.

Deepak Shenoy said...

Rohit, my replies:

- you'll never be able to judge your performance appropriately. I mean even the best managers can have bad years or months or such. There are very few managers who have had consistent runs of good wealth - in fact even Warren Buffet is known to have had extremely tough times. But what matters is only three things: screening (choosing the right stocks), position sizing (how much you invest in a stock compared to your portfolio), risk management (stop losses or things like p/e based asset allocation).

The three work in tandem - you can (and will) pick the wrong stock, but the risk and position rules will get you out before you lose too much.

In general, the experience that you get by working with your investments helps you work lesser and lesser on them to see better results.

Also, even Five years is not enough to judge your performance. You need to go through long bear and bull phases to show returns.

- Managing your own money: From an asset allocation perspective, you are probably more qualified to do it than most advisors. You know how much you can risk, and the debt part you can invest through mutual funds. For equities, you seem to be a better investor than many funds - remember that you should not take absolute performance only, take also any drawdowns (i.e. how much better have you done in a downturn compared to the funds you own) Technically this is using a sharpe ratio (or a standard deviation based measure) which you can use to see how good your returns are.

- 30% per annum over 8 years is fabulous. If every single year has been positive, that's even better. And in 8 years you have seen one bear market, two bull market and at least two serious bull market corrections plus whatever will happen this year.

You are very good already. I am very risk tolerant and believe that the best comes out of you when you don't have a cushion. But your style will vary, and to me it seems like it's just a matter of time before you take your investments to the next level!

All the best though, and remember also that the best investors are faceless and anonymous.

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