Saturday, November 03, 2007

Delegation or Dereliction ?

I have been thinking about this idea for quite some time, but only recently did I decide to blog about it. This title basically addresses the issue of whether one should be an active or passive investor. An active investor is defined as one who constantly reads up on business news, reviews and analyzes macro-events and company-specific events and generally is interested in the entire investing process and the hard work that comes with it. A passive investor is one who does not take an active role in managing his investments, and may delegate part of or all of it to another party. Note that passive investing also includes index investing, and throughout this entire article I will call passive investing a form of “delegation”, and discuss if it amounts to dereliction (forsaking of duties).

Value investing is a form of investing which involves a significant amount of active involvement, whether it be in the investing process or analyzing the companies in which one is interested in investing in. On the other hand, buying into mutual funds (unit trusts) or doing index investing is a passive form of investing, as it requires the investor to hand over the control of his portfolio to the “experts” who deem to have more knowledge than the common man on the street. Such delegation may or may not be a good thing if one considers the fact that fund managers may not have the requisite skills or knowledge to consistently do better than the market index. But does this necessarily amount to dereliction ? First of all, the most important question is how to define the term, and see if it impacts positively or negatively on the investment decisions which one makes.

For a passive investor, he prefers to delegate part of the investing process to another professional, usually an expert on certain industries or countries, in the hope that the returns generated can beat the market average. Most investors would use the market average as a benchmark to gauge their performance, and the fact is that sometimes delegating one’s investing (whether to a friend, a relative, family member or fund manager) just may not give the comfort level that the person can beat the market average. Warren Buffett actually recommends a “sloth-like” approach to investing, whereby an investor (after selecting the right companies) can just sit back and watch the value of his holdings grow instead of fervently trading in and out in order to “maximize” his returns. The problem lies with the fact that for most delegators, they have yet to build up a decent portfolio of good companies, yet they choose to take their hands off the investment process, hoping that somehow, the person who has been delegated to invest on their behalf can achieve supernormal returns. So far, this has happened only 5% of the time as 95% of professional funds managers under-perform the index due to high churn rates and frequent transaction costs.

Thus, I would still consider delegation a form of dereliction (I know this sounds controversial) as I believe that no matter how much you think you do not know, or how lazy you are, it is still YOUR money after all and you have a responsibility for ensuring it grows at a rate better than inflation rate. In fact, the only form of passive investing which can give you market returns is index investing. Although passive investing prevents you from losing big, it also prevents you from achieving exceptional returns.

2 comments:

flinger said...

Hi Music Whiz,

I think you have combined the various forms of passive investing into one article and stereotyped that all passive forms of investing is not really good and they are basically passing the responsibilties to the fund managers etc.

I think it has to be clarified especially if you are doing index investing through ETF's that there is quite a bit of research work that needs to be done to choose and create a proper asset allocation and then a proper maintenance through rebalancing work.

I think even if you let fund managers manage your funds, the investor should do research to understand what is been done, on how it impacts the investor.

I agree with you if you say that all passive investor does is just hand over the money and expect to make money.

Just my thoughts. =)

musicwhiz said...

Hi flinger,

Yes, thanks for the tip and sorry I miseed your comment from March. Must have been pretty tied up at the time.

3 months after your comments, I have learnt that some people do quite a bit of research into funds and "passive" investing as well, to the extent of knowing the fund company and fund manager; so what you say is indeed accurate.

My post at the time may not have reflected my learning at this phase of my investing life, and for that omission, I apologize.

Passive investing can be lucrative as well but one must do his homework. Index investing is also a good way to leave your money in as expense ratio is low and indices will generally return about 7-8% over time.

Regards,
Musicwhiz