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Tuesday, January 5, 2010

About Active vs. Passive investment strategies

There are basically two kinds of investors - those who follow active investment strategies and those who follow passive investment strategies. (I am excluding those who trade on a daily basis, whether in the cash market or the F&O market.)

Some Active investment strategies

1. Looking for new stock ideas: constantly looking to buy stocks that are being overlooked by the market, or selling stocks that have started to drop off after a brief rise

2. Identifying sector rotation: try to outguess the market about which sector will be the next 'hot' one (in bull phases), or 'dumped' one (in bear phases) and try to buy or sell ahead of the market

3. Frequently booking small profits: every time a stock moves up or down by 10% or 20%, lock the profits and hunt for the next stock to repeat the process

4. Using a 'ladder' or 'pyramid' approach: keep buying more in stages as a stock moves up or selling more when a stock starts to fall; contrarian investors may do just the opposite

Some Passive investment strategies

1. Identifying fundamentally strong stocks: spending a lot of time in initial research to choose only those stocks that have performed well in the past through bull and bear markets, and are likely to continue to do well in future

2. Choosing sectors within 'Circle of Competence': selecting stocks from only those sectors about which the investor has in-depth knowledge about operations, competition and growth prospects

3. Booking partial profits: when markets reach near an intermediate top (or bottom), booking partial profits (or partially covering shorts)

4. Lump-sum buying or selling: buying large quantities in a few stocks near market bottoms, waiting patiently for the stocks to rise several-fold, then selling large quantities when valuations suggest a market top

Both strategies carry a certain amount of risk. An active investment strategy tries to exploit short-term market movements on a regular basis. This carries an extra risk of the stock or sector calls going wrong. There might be a tendency to become a long-term investor by default, to avoid immediate cash losses.

Passive investment strategies also carry the risk of investments not performing up to expectations even after holding for a longer period, and may have to be sold off at a meager profit or even a loss.

The kind of investing strategy you want to follow should depend on why you are investing in stocks. Saying 'to make money' is a cop-out. Every one has to make money to survive - whether he is a big-shot, or a clerk or a peon.

Stock market investing should be for long-term wealth building that complements regular income from a job or business. It is for individual investors to decide whether active investment strategies or passive investment strategies are more conducive to long-term wealth creation.

As in life, so in investing - it may be better to strike a balance between the two. As a conservative long-term investor, I prefer to follow passive investment strategies for my 'core portfolio' and active investment strategies for my 'mad money portfolio.

What do readers think? Is it better to be an active investor or a passive one?

Related Posts

How to build wealth using a buy and hold strategy
What is your Circle of Competence?
Are you an irrational investor?


Eswar Santhosh said...

For me, there is no charm in being an active investor like the way you have described. 20% in two weeks is great if annualized, but I prefer a steadier 50% in 6 months or a doubler within a year's time. That fits my mental make-up better.

Though I cannot say that I made the right choices or had the right amount of money to invest, the bear market was my happiest time. I found reasonable valuations and was interested to sit in front of the trading screen. When the bull roars, I usually step back and spend time with life. Bulls' roars are sweet sound to tip/trick-ster's ears. I am mostly content with Opeth or Mozart :-)

Unlike the last bull run, nowadays I keep a constant vigil (not every day so I may miss the peaks, but every weekend) and try to book part profits in what I find as over valued / after a significant run-up. However, market forces could still double or triple the stock price from that point on.

That said, I've my own share of blunders trying to be actively involved (think of everything wrong - tip based investing, selling a multi-bagger early, Options without observation, even a brief with Commodities :-)). Even though the losses were large enough, I've been lucky to compensate them more than enough through profits from my investments.

But, I'd say I cannot yet be termed as a passive investor though I do have core, psychotic and even a minuscule mentally written off portion. My "experience" is hardly 5 years. So, do not know if I will keep this thing going, say by 2015.

Secondly, I was a bit "lucky" to start investing in 2004 when valuations were reasonable post the election crash. I've held on to many of those stocks till date. If I had started investing in 2006 Q1 or 2007 Q2, I might not have the same mentality.

Rishi said...


Thanks as always for the wonderful article.
Are there any common factors/parameters to look for companies that have performed well in the bear and bull phase of the economy?
Is +ve Cash flow from operations a good indicator during bear phase?
Which instrument do you prefer to hold the cash in, when you feel the market is in consolidation phase or over-valued or awaiting for a major correction?


Subhankar said...

@Eswar: Self awareness and not repeating mistakes are two important traits in life, and in investments.

The fact that you are aware of what works and doesn't work in investing will enable you to improve and fine tune your investing strategies.

Above all, one needs to curb the impulse to buy and sell. One should stick to an investing discipline that works.

@Rishi: Good questions. As a general rule, companies that protect the downside during bear markets have positive free cash flows and low debt - FMCG and Pharma companies fall in this category. Such companies also tend to underperform in bull markets.

The high-fliers of bull markets get hammered during bear phases.

I prefer to hold some portion of my portfolio in cash at all times - to enable me to take advantage of sudden opportunities. It usually sits in my savings bank.