Many personal finance bloggers and personal finance gurus are in favor of passive investing. Invest your money in the market portfolio rather than trying to beat the market through selecting investments and trading. The logic behind this advice is that the sum of all "alpha" - risk-adjusted above market returns - is zero - unlike in Lake Wobegon, not everyone can be above average. The assumption is that the the above market returns are either distributed randomly or are flowing to the Goldman Sachs and Warren Buffetts etc. of this world. It is true that the majority of mutual funds have negative alpha. So why not minimize costs and invest in the market portfolio at the lowest possible?
In thinking about trading as a business an idea came to me.
Many of the same people who are opposed to trading and are in favor of passive investing also strongly favor entrepreneurship and starting your own business. But on average all businesses make the average rate of return on capital. Some are very successful and some fail. Why does it make sense to invest in your own business if it doesn't make sense to be selective in investing in other businesses through the stock market?
5 comments:
more than a few of the people I know who have businesses pull out their capital in 3 yrs and THEREAFTER they continue to make 15% returns.
the capital is then redeployed and in another 3 yrs, the biz is generating a total of 30%.
I guess this is why people are drawn to business.
i've seen this in the food busines, hotel biz, car washes/gas pumps, and food-supply biz. The only thing stopping me from getting into this is that the 1 common trait they have is the ability to work 12 hrs 6-7 days a week. (some of them still at it after 10 yrs)
And the fact that the money required for entry keeps increasing along with my net worth, so its always just out of reach.
So you don't know anyone whose business failed?
You need to at least make what would be a comparable salary elsewhere PLUS a reasonable return on capital in order to make an economic profit. The lowest possible return on capital one could consider is 10% which has been the long-run return on stocks. 15% or so sounds like a more reasonable risk-adjusted return. So do they make 15% plus a salary? The successful businesses will beat this by a lot because of all those that fail.
PS I didn't take leverage into consider... that makes things more complicated.
PPS this was a devils advocate post. Of course I am in favor of active investing if you can find an edge - i.e. know what you are doing and the same goes in business just as in more passive investing.
Nice post. Prompted me to think.
My theory for every single person that believes Warren Buffet's investment style is the best thing in the world, is to understand that Buffet fully and completely owns his businesses. Meaning, he can alter his "return" by changing management rules or the managers (and he does so).
The risk is lower when you own management control on a business.
Most people that want to buy shares in an open market and hold forever have no such control, and their only way out in bad times is to sell at a loss. At that time, they blame themselves for thinking they could be like Buffet, when in fact their problem was they never had the biggest advantage he had.
Entrepreneurs are Buffets - they own management control and can influence the risk downwards.
Can active management give you the same thing? Not from their current approach, apparently.
That's an important point, though Buffett rarely changes managers, he tries to buy companies where he can keep management in place. In other words he tries to select a good manager up front. Of course Berkshire also owns billions of stocks in partial positions. Buffett is on the board of some of those companies (e.g. Washington Post) but most of them he's not. I don't believe in buying stocks and holding them forever. You need to monitor them or to select investment managers who are going to do so. And when things seem to begin to deteriorate sell.
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