There are only so many aspects of the investing process that we can control. Categorizing these elements will serve as an outline for our research. Let’s outline the active management process and try to leave no aspect uncovered. Your comments here—on elements that I’ve missed—would be much appreciated!
This outline will be for a portfolio of stocks only. Several of these elements blend together.
This is a huge category. But ultimately every active manager is collecting, adjusting, and processing data, evaluating that data (deciding what matters and what doesn’t), and reaching buy/sell decisions. Active managers approach these three steps in a million ways. We will do our best to evaluate each of the three levels.
- Concentration & Portfolio Construction
How many stocks should you own? How much diversification is too much? We will explore this under appreciated topic in detail, mainly in the context of factor investing.
- Trading frequency and method, time horizon
This overlaps with portfolio construction. How does a manager put their strategy into action? This includes behavioral foibles, because buy and sell decisions are often the result of our mis-calibrated psychology. Turnover is demonized, but in order for some of the best investment strategies to work (e.g. momentum), turnover is necessary.
- Market impact
Donald Rumsfeld might call these costs the “known knowns” in investing. We can keep costs down in a number of different ways to avoid what Jack Bogle calls “the tyranny of compounding costs.” These will be important to consider alongside #3. The key is a balance of costs with the benefits expected by incurring those costs.
We will consider these important categories in isolation. What are the options within each? What are the relative merits and dangers of each option? How can investors find the style that best suits their needs and their temperaments?
While important in isolation, these categories are most important in combination. For example, it may make sense to concentrate a value-based portfolio more than a momentum-based portfolio. Ditto for trading/rebalance strategies.
There are never silver bullets in investing. There is no perfect strategy. There are a number of strategies—themselves quite different from one another—that have worked well historically.
There is no one statistic that is best for evaluating a strategy, either. Instead, a suite of statistics is best: t-stats, returns, consistency (base rates), sortinos, omega ratios, drawdowns, diversification, liquidity, and so on.
Perfect is the enemy of good, in this case. Nothing will be perfect, but perhaps we can put the odds more firmly in our favor.
What have I missed? What else should we consider? Let me know in the comments below.
P.S. Luck would be a fifth and final determining factor—one that is sadly out of our control. We can investigate measures of skill like information ratio, but there will always be some component of luck in any investment outcome.