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A Modest Proposal For Hopeful Stock and Fund Pickers

Aug 1, 2008 Blog, Blogging, Make money in blogging

I believe in holding a diversified, low-cost, passive investment portfolio. However, at the same time there is so much financial hype out there that I understand the natural tendency of people (especially intelligent, hard-working, competitive people) to actively manage their investments. They may think they can pick the best growth stocks like AAPL or GOOG, they may be Buffett disciples and search for durable competitive advantages, or they may be stable dividend seekers. Or maybe they just want to pick the best fund managers instead.

But what if you suck at it? By investing in low-cost index funds, you are essentially guaranteeing yourself to be somewhat above average every year. Wander off-course, and you could do great, or more likely you could crash and burn.

Many people decide mitigate this risk by doing some form of Core and Explore investing, where you keep most of your money in passive funds and gamble a bit with the rest. Since I do this myself to a (very) small degree, I’ve been toying with an idea that takes this one step further.

1. Start Out Small
Let’s say you are young and aggressive, and want your portfolio 100% stocks. Let’s say you carve out 5% of that, throw it into a cheap discount broker, and start trying some ideas out.

2. Track Your Performance Honestly

Thinking you’re doing well at stock-picking without knowing your relative performance is like running around the track alone with no stopwatch and saying “Gee, I’m fast!”. To gauge your self properly, you need to:

1. Keep track of all investment inflows and outflows. This means keeping track of all your contributions, buys, sells, and fees/commissions paid.
2. Account for uninvested cash. If you would have put $1,000 into an index fund, but instead bought $500 of GE, that means you also have $500 of idle cash earning 0-4%.
3. Calculate your return properly, taking into account the information from the previous two steps. Here are two ways, one provides an estimate while the other gives more accurate numbers.
4. Pick the appropriate passive benchmark portfolio. For example, the S&P 500 only works if you are investing in large, US-based companies.

3. Adjust Based On Your Relative Performance
You should run a comparison with your benchmark regularly. Each year that you beat your benchmark, you can increase the percentage of your portfolio which you actively manage. If you lag behind the benchmark, you must decrease the percentage of your portfolio which you actively manage. A really crude rule might be simply to increase or decrease the active amount by 2% each year based on performance.

If you are truly horrible, you’ll be out of stock-picking completely in a few years. For most people, you’ll probably be out of it within a decade or so, having learned a valuable lesson. If you are the proper mix of skillful and lucky, then soon you’ll be controlling the entire portfolio.

Sound reasonable?