Guest Post By “TheEngineeringInvestor”
Personal finance is the tool for which many can use to unlock the goals they have in life. Be it saving for a new car, house or retirement, it offers a path to increasing our financial security and keeping our accounts in check.
When planning for retirement or saving, many turn to the stock market. This is a great tool where investors can pool money into public companies helping them growth and return profit to you, the investor along with other investors. Historically, the best way to do this has been to buy individual stocks through your brokerage (Active Investing). This comes with the good and the bad: good being that you might generate massive returns by picking the right companies. Bad being that it is impossible to predict the next Amazon or Google.
An alternative to this was proposed by John Bogle in the 80s with the invention of the passive index fund. These simply track an index (like the S&P500) at a low expense ratio. This is passive as you do not have to individually select the company most likely to perform well and avoid high management fees from holding individual stocks or actively managed mutual funds.
So why not passively invest in an index?
As an individual investor, I do not invest in passively managed index funds. This may seem counter-intuitive to some however. Below are some of the reasons I choose active investing:
- Learn new skills
- Build a playbook for all market conditions
- I enjoy the challenge and the game of investing
- Avoid systematic risk – maintain control and compound wealth quicker
- Can’t time the market
- Career (work) is a time/money direct exchange. No leverage of time or compounding of wealth available.
- Investing is the compounding of knowledge and money over time into securities which fit my risk criteria
Having started active investing, which is both a skill and a hobby, I have been able to learn numerous skills which will benefit me personally and my career. This includes advanced MS Excel skills to build valuation models, building communication and presentation skills to present research to peer investors. As an aside to my investing, I have since built my blog! This has allowed me to become a better writer as well as engage in social media marketing and SEO.
Building a diversified and active playbook allows me to trade shorter term instruments and longer term investments inside a portfolio. I can concentrate positions in small cap equities and rotate out of positions that don’t fit my style. I can compound wealth and knowledge and expand my market horizons into global Macro investing and equity derivatives for hedging purposes only.
Increasingly in the S&P 500, the index is becoming a skew of big tech at the expense of everything else. The market is overvalued on fundamental metrics (P/E, with government debts at an all time high. These kind of market conditions are difficult to manage well, and the risk of draw-down to major indices is elevated. This is where it is beneficial to have a diversified set of strategies to hedge out long only equity risk.
Many argue for diversification. While this logic may seem sensible for some, it is currently flawed for two reasons. First, typical 60/40 construction suffers from recency bias and does not consider a scenario where, like today, yields on bonds are negative on a real basis. Second, diversification is a way of preserving wealth, not building it. As a young investor, I can afford to take increased risks in concentrated bets to build wealth, rather than using diversification to maintain it.
Investing in an index is a simple way to guarantee a mediocre return. The common misconception is that by cost averaging into an index every month you are GUARANTEED ~8% return by the index. The caveat to this is the price paid determines the return and a higher price indicates a lower return as denoted by the Buffett yardstick which is currently at 183%. (03/09/2020)
Investing allows the compounding of wealth and time to provide a capital gain, potential for income once a scale is achieved, and can invest in securities and asset classes which fit my risk criteria.
Given this high overvaluation in US equities, volatility and unprecedented times surrounding global geopolitics, it pays to make high conviction concentrated bets and remain flexible through active investing.