This is the payoff chapter. Here you can determine whether it is worth your time and effort to even attempt to “do better” than the majority of investors. But first a quick classification: Just who are these passive and active investors I speak about?

One way to sort shareholders, in a psychological sense, is by how long they hold their investments. Active investors can be characterized by short-term holding periods—a year or less, by some standards—because they tend to turn over their portfolios quite frequently. On the other side of the spectrum are the purely passive investors, people who buy and hold until retirement, although they typically add cash to their plans on a periodic basis. In the middle are the intermediate investors, those who tend to hold on to the allocations in their portfolios but from time to time turn them over.

The reasons why investors fall into these different categories vary. Passive investors might be smart enough to understand that investing broadly in the stock and bond markets pays very well over time. Yet they might be too inhibited or risk-averse to want to fiddle with an allocation that, based on the historical data, will deliver them sound gains. Or maybe they just don’t want the hassles involved with active investing—or the fees; active plans often are managed by brokerages or investment banks that want to get paid for their services.

Active investors, on the flip side, might be attracted to making the most money they can out of the stock market; maybe they have a penchant toward risk-taking and also believe that they possess superior short-term information on which to act. As for the intermediate investors, maybe they change their beliefs about the future direction of the stock market every once in a while, sometimes profoundly enough to drive them to adjust their portfolios.

The upshot of these three strategies is the same: Each seeks to make the most from the stock market based on a given level of risk. So a question: Which style of investment dress best fits your frame?

As you might suspect, the correct answer is a trick answer: Each can be a perfect fit at different times. This is a fundamental concept that I build throughout this book. But for now, here are the basics of why one strategy “size” does not fit all investors for all time: The level of transaction costs related to stock investing is relatively low when compared with other forms of investing, although these costs periodically trend higher or lower (helping increase or decrease the “hurdle” between investments); credible information relative to the expected direction of stocks and bonds exists (period); and the differential of returns between current and new investments (or the “extra” return that one investment offers relative to another) rises and falls, depending on the nature of different stock markets. From these considerations, we can derive two general investment rules—in essence, the basics of a switching strategy:

Qualitatively, this should sound reasonable: When the costs of taking action are high, stay put; when they are low, take action. But the quantitative argument for a switching formula might strike you as even more persuasive because, I presume, we all are interested in achieving the highest investment payoff possible.

On to the data.

In all probability, investors purchase stocks and bonds to add to their net worth, so we can say that any investment plan that generates capital gains in excess of the inflation rate is making its investors richer. In determining the range of possible payoffs of a switching strategy—or a strategy that is sometimes active, other times passive—this is our performance measure. Additionally, to evaluate any investment strategy, we need to assume that the past is a good guide to the future if the data sample is long enough. For this study, I have used data collected from the S&P 500 for the period between January 1962 and December 2004. By the standards of modern stock market analysts, 42 years and 9 months of data easily meets the requirement of being “long enough.”

Overall, I calculated 513 one-year and 285 twenty-year holding periods, with the number of intermediate holding periods falling in between.^[1] Table 3.1 shows the results. For this argument, you can think of the one-year holding period as the one-year horizon of an active investor. This investor is very active; never does this year’s portfolio look exactly like last year’s. The 20-year period can be considered the horizon of a passive investor. This investor bought a reasoned allocation to stocks and bonds and held it for two decades. Finally, the 5-, 10-, and 15-year periods correspond to a range of intermediate horizons.

How did the strategies do?

The 20-year horizon produced an average maximum gain of 8.19 percent per year over and above the inflation rate and an average minimum return of 0.14 percent per year. That’s a wide range for the passive strategy, but note that there were no losers: The number of negative returns was zero. In other words, investors in this crowd never lost money.

If past gains are representative of future gains, the 0.14 percent minimum annual return suggests that there is little or no chance of a 20-year holding period ever producing a negative outcome. This may be more firm evidence that stock market investing is worth your time, but can anyone say, “Buy and hold?”

Well, not holding has its advantages, too.

As the holding periods shorten—moving away from the purely passive strategy, through the intermediate strategies, and then to the active strategy—the upside, as measured by the average returns, also increases. Watch the maximum average inflation-adjusted gains ascend proportionately as the holding periods decline in length: 20 years, 8.19 percent; 15 years, 9.85 percent; 10 years, 13.35 percent; 5 years, 22.68 percent; 1 year, 58.26 percent.

Importantly, however, as the holding periods turn shorter, the number and magnitude of the negative outcomes increase. Now watch the minimum average inflation-adjusted gains decline proportionately as the holding periods shorten: 20 years, 0.14 percent; 15 years, –5.49 percent; 10 years, –7.96 percent; 5 years, –17.67 percent; 1 year, –76.52 percent.

Further reinforcing the downside of active investing is the fact that the frequency of negative outcomes increases as the length of the holding periods declines. Negative returns made up 17.39 percent of the returns for the 15-year horizon, 24.69 percent of the returns for the 10-year horizon, and 34.11 percent of the returns for the 1-year horizon.^[2] The passive, 20-year negative outcome of zero seemingly laughs at such downside potential.

From this perspective, the data clearly supports the long-term buy-and-hold strategy. Thus, a risk-averse person possessing this data might choose the safe path of passive investing over the long haul. But in doing so, such a risk-averse person eliminates the potential (and potentially large) upsides that partner with the shorter, more active holding periods.

What to do?

Are you, for instance, willing to give up the potential upsides of an active strategy to protect yourself from the negative returns that can accompany that strategy? Will a 20-year average annual return in the range of 0.14 percent to 8.19 percent, with virtually no chance that you will fall below this range, meet your investing aspirations? Or are you enticed by that 58.26 one-year return, the one that coincides with a 34 percent chance of a negative outcome? According to the data, your prospect of witnessing a negative result are one in three if you take this route—175 out of 513 one-year periods in the sample, with an average decline of 16.56 percent.

Well, what if those negative outcomes can be avoided—at least, most of the time? Theoretically, an investor can use superior knowledge to avoid the down markets and increase his or her average returns to a handsome level, which, based on our data sample, would be approximately 13.39 percent per year—far superior to the best 20-year passive outcome.^[3] Such a return is not far-fetched if one believes superior knowledge not only can be acquired, but can steer an investor away from bad investments and toward good ones. Again, this is the topic of the book you are reading, and for now, we are simply interested in the possible payoffs of the most active and passive strategies and those that fall in between.

Table 3.2 should give you a sense of both the risks and rewards that are at stake. In this table, I have calculated the distribution of returns for each of the sample holding periods, providing something of a grading system for stock market performance. For instance, if you ranked in the 90th percentile for a holding period, you ran with the top 10 percent of performers for that period. That’s an A+ grade.

Where might you fit in?

The far-right column in the table provides a sense of the range of opportunities for the buy-and-hold, or purely passive, strategy; the far-left column does the same for the purely active strategy. In the passive strategy, we again see a wide range of results—from 1.77 percent for the 10th, or worst-performing, percentile to 7.63 percent for the 90th, or best-performing, percentile. And there is an implicit randomness to these returns. Simply, because some two-decade stock markets are a lot better than others, how you perform in a passive long-run strategy has a lot to do with the date you start.

Moving leftward across the table, or from passive to active, that scenario changes. In a critical sense, the more active you get, the more your returns are in your own hands because every switch you make between investments presumably is based on the information you possess.

Let’s consider the 15-year holding period: Here the range of possible outcomes widens to include a worst-performing return of –1.7 percent and a best-performing return of 8.9 percent. You can do better in this strategy than the pure-passive strategy, and you also can turn in a negative result. But think of this: If you ranked in the 90th percentile of the 20-year strategy, you performed worse than you would have if you had ranked in the 80th percentile of the 15-year strategy. In other words, your performance ranking could have been lower in a slightly more active strategy, and you still could have performed better than the best purely passive performance. In fact, the top performance of the passive buy-and-hold strategy is only slightly above the 70th percentile of the 15-year strategy. Sliding left to the 10-year holding period, you would need to rank only among the top half of performers to eclipse the best 20-year passive-only result.

Obviously, you don’t have to be the best active investor, possessing the best information, to beat the best passive-investing result. Is this proof somehow that active investing is superior to passive investing? Not quite.

The bolded numbers in Table 3.2 paint an instructive picture. As one moves left, from passive to active, notice how the range of purely passive returns from the 20-year holding period squeezes into a tighter and tighter window. Because the purely passive return is the market-average long-run return, all of these bolded numbers represent the opportunity set for average investors—people who possess neither superior nor inferior information on which to act and earn within the range of the average market rate of returns. A question: If there is a tighter window in which to earn the same average returns the more active one gets, why attempt to earn those returns in an active manner? Basically, there is no reason to do so. To begin, these average returns will cost you more to earn if you earn them actively. Why? Transaction costs. Simply, the more your strategy switches investments, the more your strategy will cost you. Then there’s the incidence of negative returns. The more active you go, the greater your chances are of falling on your face.

Clearly, if you are going to turn in an average result—or if the information you possess will return you only average results—keep it simple and invest in a passive, long-run, buy-and-hold manner.

As for the unbolded numbers in the table, those in the bottom range are ugly, to say the least. Basically, these returns apply to active investors with inferior information—each is an incidence of falling on one’s face. On the flip side, however, the unbolded numbers in the upper range of the table represent the opportunity set for active investors with superior information. It is a tighter sweet spot than the bolded average returns, but it’s certainly a much sweeter sweet spot. To land here—in a range that encompasses several strategies, from very active to mostly passive—one needs only superior information on which to base investment action.

We deal with how to acquire that information in the chapters ahead, but now you know what you’re aiming for.

Psychiatrists have famously used Rorschach tests to uncover the fixations of their patients, often with wildly dissimilar results. You might easily imagine something like the following: One day, holding up a card with blobs of black ink on it, a psychiatrist asks his patient, “What does this look like to you?” His patient responds, “An onion riding a camel.” The next day, the doctor holds up the same card to a different patient and asks the same question, “What does this look like to you?” The second patient responds, “A noose, hanging a coat rack.” The realm of responses is probably infinite and hardly predictable without any prior knowledge of what makes a patient tick.

Investors, of course, are attracted by predictability. At the least, when acting passively, they believe the market will inevitably rise over the long run. At the other extreme, when behaving actively, they believe they possess enough information to predict turns in the market and take advantage of those turns—believing that the gains of alternative investments will be large enough to compensate for any new transaction costs while coming in over and above the gains of previous investments.

As I’ve mentioned, I’m interested in both strategies. I also believe that every stock market environment is predictable based on the economic forces of the day. How predictable?

For fun, and a little instruction in this regard, I’ve put together a Rorschach test of my own. Figures 3.1 and 3.2 show my two “cards.” Rather than think like a patient, think like an investor. What are these cards telling you?

Figure 3.1. 

Figure 3.2. 

If you are thinking like an investor, Figure 3.1 might suggest tremendous volatility—lots of ups and downs, although with a regular passing-through of a middle ground. Contrastingly, Figure 3.2 might suggest a thing that rises over time, although with a few bumps along the way. If you understood each card in such a manner, I’d give you a clean bill of health.

Figure 3.1 is, in fact, the return net of inflation that you would have earned by holding the S&P 500 for one year, starting at various points in time during the period from 1962 through 2005. The volatility and the potential negatives of the one-year holding period are patently evident. As you might now guess, Figure 3.2 tracks the 20-year holding-period returns of the S&P 500 across the same time frame. The long-run result is upward overall and appears highly predictable.

The visual representations of these two holding periods suggest that there will be many fluctuations during the short term and that these fluctuations will wash out over time. This phenomenon is related to the concept of mean reversion: What goes up must come back down; what goes down must come back up. However, what if the disturbances that are so evident on the one-year card can be anticipated? If they can, it might be possible to anticipate the mean-reversion adjustment process, in effect, adjusting to a thing that will likely go up and readjusting to a thing that will likely come down.

Let’s look at the data in Figure 3.1 again but this time in light of the left axis (the price performance of the S&P 500) and the bottom axis (the years 1962 to 2005)—see Figure 3.3.

Figure 3.3. Real S&P 500 total returns: 1-year holding periods

The fact that the bulk of the worst negative (below-the-line) returns occurs during the high-inflation 1970s and the period after the millennium bubble burst suggests that an understanding of what caused these periods of underperformance would have helped an investor anticipate them. The length of the underperforming periods is also instructive. Roughly, market dips and surges last around five years, which suggests that there is a cyclical, nonrandom, and predictable nature to the stock market, just as there is a cyclical and predictable nature to the buy-and-hold home-owning strategy, with the average holding period lasting five to seven years. And practically speaking, five or so years is a wide target, plenty of time for you to adjust your investments toward the profit-making specifics of each stock market.

Indeed, dressing appropriately for the stock market is not an activity that will have you in your closet (i.e., your portfolio) every day. The climate of the stock market generally changes gradually, just like the seasons, and over the course of a season, the weather is usually predictable.

On the first day of winter in Boston, it might be 55°F and sunny, but if you live there, you know with certainty that the chill winds and snow are on their way. You prepare accordingly. In this sense, if a stock market “season” lasts a few years, one or several months of being misallocated (or even a year or so) will not eliminate all the potential gains generated by a proper anticipation of, and allocation to, that season. And when those “natural disasters” occur in the stock and bond markets, there is still no cause for alarm: An adjustment process must occur following every economic shock that will restore the economy to its long-run equilibrium. And like the seasons, those adjustment processes can be anticipated and acted upon.

And if you do act upon those adjustment processes, I can guarantee that you will be generating above-average performance more often than not.

Risk has risen to a prominent place in this argument: As an investor, you must choose a way to evaluate the trade-offs between the risks and returns offered by the different strategies at your disposal. But I tend to think of risk, or risk aversion, in relation to one’s level of knowledge. Simply, I don’t think it’s chancy to take advantage of your understanding of a certain set of circumstances. If, armed with the knowledge of how markets are likely to react, you adjust your investments to avoid the negative outcomes and accentuate the positive ones, taking advantage of the best strategies for the economic times, you will likely significantly enhance your investment returns over the long run.

At this point, far from stock-picking, we’re talking about strategy-picking. When you think of the thousands of possible stocks to choose from versus the relatively few strategies to select, the strategy-picking approach should seem much less daunting—and, hopefully, much more promising. Of course, your results will be based on your ability to predict turns in the market. But if those turns are predictable—or nonrandom—well, they can be predicted.

I sometimes have the sense that risk-averse, stereotypically passive investors think the information necessary to make serious gains in the stock market—to predict those market turns—is attainable only by the greatest minds or the most well connected. But all investors can be the bearers of the right information on which to better their performance. That’s not to say good information is foolproof. The best active investors make a few bad calls during their careers, even when they possess good information from which to draw the appropriate conclusions. In other words, risk is always a factor—but risk is justified over time as the correct calls are made more and more often.

How much of a downside are you willing to risk to realize a higher upside? The better your understanding is of the various macroeconomic forces—the theme for the remainder of this book—the easier that question is to answer.