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Active vs. Passive: You're Kidding, Right? image

To be sure, there is no shortage of free "research" available these days. Everywhere one turns, there is a fresh white paper from any number of experts espousing this or that. But recently there has been a raft of papers on the question of passive investing versus active investing. And cutting to the chase, this particular question isn't even worth asking.

The bottom line on this debate - and this is indeed one of the more lively debates in the investing game - is that when used consistently, an active approach (aka a buy-and-sell strategy) beats the passive buy-and-hope approach hands down. It's no contest.

The Decade Where Buy-and-Hope Went to Die

Yet every time the bulls start rolling for a few years, the passive crowd starts jumping up and down proclaiming that there is simply no reason for an investor to ever leave the market (or more appropriately, there is no reason to ever sell their mutual funds!).

Never mind the 50+ percent drubbing that occurred when the "technology bubble" burst between 2000 and 2002. Forget about that 55 percent loss created by the "credit crisis" between 2008 and early 2009. Just buy and hold, it'll be fine!

While it may be true that the blue chip indices have recovered nicely from the two monster bear markets that occurred between 2000 and early 2009, a great many investors, as well as the NASDAQ composite have not. In fact, although the S&P 500, the Russell 2000, and the S&P 400 Midcap indices all hit record highs this week, the NASDAQ still needs to gain more than 1100 points - or almost 29 percent - in order reach the all-time high set in early 2000.

So, if an investor was technology-oriented at the turn of the century and owned a big slug of the NASDAQ index via mutual funds or ETFs, they are still waiting to get back to breakeven. For most investors, being forced to wait for thirteen years to get back to where they started at the turn of the century isn't a realistic expectation - especially when the market crashes and burns not once but twice during that period!

There Is a Better Way

The first point is that most investors don't have the emotional make-up to "set it and forget it" when their retirement is on the line. Nope, when an investor watches their "401K turn into a 201K" all that "long-term" stuff they agreed to when they started investing tends to go right out the window.

As such, having a strategy to get the heck out of the way when the bears come to call and then to re-enter the market when the bulls return and the bears go back into hibernation, is the way to go. In fact, it is a safe bet that the vast majority of investors would love to have such a strategy in place going forward.

Yes Virginia, You Can Beat The Market

While the Vanguard's of the world have spent gazillions of dollars trying to convince the public that there is simply no way to beat the market, their argument is patently false. There are any number of strategies that will handily outperform the stock market over long periods of time.

To prove the point, let's review a handful of strategies designed to (a) keep investors in stocks during bull markets and (b) get investors out of stocks during bear markets.

A Trend-Following System

Trend-following gets a bad rap because while such a strategy can keep one on the right side of the really big moves, it can also chop up an investor during whipsaw periods. But with that said, take a look at the chart below.

S&P 500 Monthly & 15-Month MA

The black line is the S&P 500 on a monthly, closing basis. The blue line is a 15-month, weighted moving average, which has been moved forward two periods. The idea is to buy and hold when the S&P is above the blue line and then move to a short position when the S&P is below the blue line.

Since 1995, assuming no trading costs, the hypothetical trend-following system would have shown a return of 555.6 percent while the buy-and-hold approach would have sported a return of 281.5%. Not bad, eh?

A Sentiment System

Another approach would be to buy stocks when sentiment indicators say investors have become too bearish and sell when they are too bullish. Using data from Investor's Intelligence, one can craft a strategy that has given sell signals before the big declines seen in 1974, 1977, 1987, 1998, 2000, 2008 and 2011. In fact 94% of the trades since September 4, 1970 would have been accurate. Again, not too shabby, right?

A Momentum System

Yet another approach is to be invested in the stock market based on the market's internal momentum. For example, studies show that when both the index and an advance/decline line are above their 45-day moving averages, the stock market has gained ground at an annualized rate of 18.2 percent per year since 1998. When both the index and the advance/decline line are below their respective moving averages, the market has lost ground. And when either the index or the A/D line (but not both) are above the moving average, stocks have gained just 6.3 percent per year. So, obviously paying attention to this approach might not be a bad idea.

A Volume-Based System

A final example of a method where an "active" investor might be able to outperform the stock market by a wide margin involves the idea of "demand volume" and "supply volume." Getting straight to the results, since 1982, this study shows that when demand volume is above supply volume, the S&P 500 has gained at a rate of 11.6 percent per year. And when supply volume is above demand volume, the S&P 500 has lost -1.2 percent per year. Although hypothetical, using such a strategy would have kept an investor out of stocks for the vast majority of both the 2000-02 and 2008 bear markets.

So Yes, One Can Beat The Market. But...

The takeaway from this oversimplified review of the active versus passive argument is there are many, many different systems that can keep investors long during bull markets and either out or short during bear markets. Therefore, there really is no debate to be had. One can indeed beat the market, if they so desire. It's that simple.

However, the key is that an investor must (a) define a strategy and then, more importantly (b) stick to the strategy when times get tough.

Anyone who has studied market history will attest that all investing strategies will struggle from time to time. And this is where all too many investors fail as they simply give up on a strategy the moment it doesn't perform up to expectations.

It is a fact that no system is perfect. No system works all the time. And no system works in all environments. Heck, even the strategy employed by the legendary Warren Buffett has been out of style at times. Does anybody remember the "Oracle of Omaha" saying he just didn't understand technology in the late 1990's?

Here is another example. That 15-month trend-following system discussed above would have nearly doubled the S&P 500 over an 18.75 year period, which is great. However, in 1998 the system would have lost -0.07 percent while the S&P gained 26.7 percent. That happened again in 2009... and in 2010... and again in 2011. For three straight years, the system would have lost money while the market was either up or flat. Now ask yourself, can you live with that?

So, the real bottom line is that investors CAN beat the market. An active approach, if designed properly, CAN keep investors out of danger when the bears come to call. But an active investor must also HAVE a system and UNDERSTAND that system so that they can live with it when it fouls up. Oh, and it WILL foul up!

But, if one has a good system and follows it, even when times are tough, they just might be able to outperform their passive friends, who insist on watching their account values be torn to shreds during bear markets.

Turning to this morning... Upbeat earnings from Microsoft (MSFT) and (AMZN) are overshadowing the lackluster report from P&G (PG) out this morning and the dismal session in Japan overnight. In Europe, investors were treated to mixed news on the economic front. However, traders in the U.S. will get a peak an an important piece of the economic puzzle this morning via the report on Orders for Durable Goods.

Positions in stocks mentioned: none

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