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Being a stock-picker is harder than it sounds: Barry Ritholtz

This Monday, Aug. 24, 2015, file photo shows the New York Stock Exchange.

Seth Wenig/AP

The rise of passive investing, which its advocates prefer to call low-cost investing , is the most dominant trend in the markets during the past decade. Sure, exchange-traded funds (ETFs); smart beta; factor investing; environmental, social and governance (ESG); impact investing; and other themes have all attracted adherents. But if we were forced to select the single biggest stylistic change in investing since the financial crisis, the embrace of low-cost indexing would likely be the one.

The problem that confronts us is the criticism that indexing is worse than Marxism, is devouring capitalism, is a lobotomized investing style that creates a "frightening" risk to markets. Or so we are told. Mostly what the articles I have linked to show is the risks not to investors but to the people who earn a living selling high-cost, underperforming investment products.

QuickTake Active vs. Passive Investing Today, we shall apply Charlie Munger's aphorism of "invert, always invert" to the active-versus-passive management debate. Set aside your biases (I'll try as well), and assume that these folks are correct, that indexing is evil, and that investors should embrace active management for at least part of their portfolios.

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What might that look like?

Begin by considering the advantages of active over passive. At this point, we are all so well aware of the disadvantages of active that it would be redundant to repeat them all here.

Active management offers the promise of several desirable goals versus passive, including: Alpha: outperformance versus a benchmark or market rate of return Expressive: investing toward a specific goal that isn't primarily financial in nature Risk management: controlling results by managing around market, sector, stylistic and other risks Behavioral: affecting decision-making by investors Let's consider each in turn.

Of all the reasons to be an active investor, alpha may be the most difficult to achieve. Someone is going to beat the market every year, and the challenge is identifying whether you can be that person -- or identify the fund managers who will be -- in advance. Picking the stocks that beat the benchmark, or alternatively, finding the stock-picker who can beat their benchmark, is no easy task. If you invest actively to achieve alpha, the latest studies suggest that the most of you will be disappointed over the long run.

Investing in order to express a particular nonfinancial viewpoint is the entire basis of ESG investing. Meir Statman of Santa Clara University, author "What Investors Really Want," has explained that this is typically an unstated desire of many market participants. Sure, they want decent returns, but they also want to use their capital as an expression of their values and belief systems. My colleague Josh Brown has described this during the Trump presidency as "#Resisting with your portfolio," and is a favourite with millennials. I expect this aspect of active investing is only going to grow over the next few decades.

Some have argued that a reason to go active is risk management: The idea of being fully invested throughout a significant correction, to say nothing of a huge crash like 2007-09, is an anathema to some. The problem with this reason is that most track records in market timing are pretty awful. There were too many people who bailed on stocks in 2008 only to become paralyzed, incapable of going back in after the bottom was reached in March 2009.

However, there are valid reasons from a behavioural perspective to be active in a portion of your holdings. I prefer a strictly rules-based quantitative approach to both buying and selling equities. The true purpose isn't to beat the market, but rather to allow you to tolerate the more severe downturns in your core buy-and-hold portfolio when it's being buffeted by a hurricane. If you can't hold on to a diversified portfolio during a bear market, a rules-driven tactical portfolio that moves some of your holdings from stocks and their risks to bonds and their safety will allow you to sleep at night.

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Higher costs aside, the problem active investors encounter is that all of these benefits are more difficult to achieve then most people believe. I am not a total curmudgeon advocating the death of active management. Indeed, I have even advised active managers on how to bring more value to their clients. But it should be recognized as a tool with specific uses toward even more specific goals.

Unfortunately, that isn't how most people use active management.

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Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of "Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy."

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