Is there a threshold (in effort, or capital) beyond which it makes sense to be an active investor?

Question

According to Benjamin Graham's The Intelligent Investor one could define an aggressive investor in accordance with the following line (not a verbatim extract from the book):

The difference between a defensive and an aggressive investor is not in the amount of risk that one is willing to take, but in the amount of time and effort one is willing to dedicate to investment.

Reading this forum, I've come across several claims that are very hard to verify, for instance:

• A great amount of fund managers are not able to outperform the market
• Due to the investment fees, it makes very little sense to trade and pick stocks and have more net return after fees than with an index fund
• The last point is due to the fact that even if you were a very brilliant investor, the amount of transactions you need to do in order to beat the market would mean that most of your returns are eaten up by fees.

These claims seem to be widespread on the site, there is no single link I can provide mentioning them, but I imagine that most of you would agree that this is indeed claimed.

Now if I can infer correctly, these last two points are very important because if true they would be true independent of the manager's ability (whilst the first item does not necessarily apply to brilliant investors).

The problem with this is that being an active investor seems to be a very dumb idea. If one reads the most voted answers on investing advice on this website, at least, the buy-and-forget index funds seems to be an universal (almost the only one) good strategy and by trying to outperform it a person is almost guaranteed to lose money.

Then what would motivate an active investor today? I am of course talking about people that would be considered in the public for the referred book, and not Hedge Fund managers or institutional investors. Does it make sense for someone to pursue being an active investor? Does it only make sense for people that actually have a lot of money or are willing to actually put a LOT of effort?

Answer 1

It's worth it to be an active investor when, net of fees, your careful stock picking can reliably beat the performance of an index fund charging 0.07% expense ratio.

However, it is not enough to beat it. You must beat it by more than the salary you would earn if you did something else with your time.

Since the earnings you make are proportional to the amount of money you invest, this greatly favors a highly capitalized trader.

Alex took $100,000 and played the market full time. Alex netted $9,000 gains for the year - very good!

Except against the 2500 hours Alex invested, this amounts to prison wages.

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Well-capitalized Ben took $1,000,000 and did exactly the same thing. Ben collected $90,000 gains for the year - ten times better than Alex simply because of having more capital in play. That sounds great, except see part 2.

Charlie slapped $100,000 in an index fund and played Fortnite for those 2500 hours in the year. Charlie made $12,000 gains. Better than Alex, and no labor involved. Paid the rent.

Diane slapped $100,000 into an index fund, and worked as a legal secretary for those 2500 hours. Diane made $12,000 capital gains + $60,000 wages. So Diane did 8 times better than Alex.

Rain Man Rob invested $100,000, doing a brilliant job picking stocks. (Or maybe just lucky?) Rob made $14,000 capital gains. For 2500 hours work.

The upshot is that trying to research and trade your own stocks, is likely to do better than $0 on average, but most likely worse than the index. Alex and Rob are earning prison wages - playing a loser's game even compared to working at McDonalds... unless you have a stupendous amount of capital to invest as did Ben.

Of course either of them has marketable skills, and could work at the least for a funds manager as a researcher. Or choose much more rewarding work of some kind. Of all these people, Diane has the best plan.

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But is the problem too little capitalization to invest? Let's try that.

Heather has Rob's skill and Ben's capitalization. Heather invests $1,000,000 and 2500 hours of time, to earn $140,000. That's better, right? Right?

Ian also invests $1,000,000 into an index fund, earning $120,000. The 2500 hours goes into sitting on a beach.

Joan does the same thing as Ian, but instead works at McDonalds for $12/hour for those 2500 hours. That adds $30,000. So Joan totals $150,000.

Ken does the same thing as Ian, but instead works as executive director of a nonprofit precious to Ken's heart, earning $70,000.

So compared to an index fund, Heather only made $20,000 vs. just sticking it in an index fund. Effectively earning $8/hour, once again showing that even with huge capitalization and demonic luck, there's no money in trading your own stocks. (least not compared to index funds).

Again, Ken has the winning play: setting investments on autopilot and working at a beloved job.

Answer 2

There is some things to consider to put this quote and your thoughts into the right place.

The book is old. The latest original is about 50 years old and the version with a commentary that I own is 20 years old. Some things have changed since then. Among those things are the widespread availability of low-cost index funds which change the game. In the 70s an investor was faced with either buying a mutual fund or investing in individual stocks directly. There was no thing such as buying an S&P500 ETF that costs you 0.07% yearly. The S&P 500 was not even a big thing back then (Graham sometimes refers to it as an "assorted collection"). Hence the recommendation for the passive (he calls it defensive) investor to simply buy a handful of well known DJIA stocks and be done. The active (aggressive) investor would instead research companies more thoroughly.

A great amount of fund managers are not able to outperform the market

Actually this is something that can be easily verified. Moreover, it is literally impossible for the majority of funds to outperform the market. Mutual funds - together with other professional money management such as pension funds, endowments, hedge funds - are the market. Individual investors play a marginal role in moving prices. If you are the market, on average you cannot beat the market.

And things just get worse from there. If you charge 2% fees, your expected after-cost return will trail the market by those 2% on average. If you have high turnover, you will have high trading costs putting you further away from the average. Keep in mind that brokerage fees are only a small part of your trading cost when managing millions. The very act of buying and selling will move prices to your disadvantage. High turnover can cause taxable events (depending on jurisdiction).

So why do funds still perform active management?
First, it is profitable. Not for the investor but for the fund company. There simply is not much to earn with a 0.07% TER compared to 1.5-2% for active funds. And do not forget commission-based salesmen living off your load fee. Those do not earn anything on an ETF.
Second, markets are not perfectly efficient. They are in an equilibrium between efficiency and inefficiency. Check for the Grossmann-Stiglitz-Paradox. There are inefficiencies that are worth exploiting. The problem is just that exploiting them without leverage often is not profitable. A great book with regard to this topic is Efficiently Inefficient, although a bit of a heavy read.

A note on individual investors
Some of the disadvantages of professional money management do not apply to retail investors. The average Joe will not move prices. They can go into small caps with all their money if they want. So the advantage slightly tilts towards active management but the recreational investor is at a severe information disadvantage. Not only is he at working during the day and will always be late to react to events but he is also at a disadvantage in analysis. Let us be honest, who will read earnings reports after work or on the weekend? With your children wanting to play with their father? Do you even have the qualification to understand what is written there? I do not. Furthermore proper diversification is difficult with a small budget. So overall an index fund offers the best balance between cost, effort and return.

Answer 3

A great answer by Manziel but it doesn't actually answer the question: Is there a threshold (in effort, or capital) beyond which it makes sense to be an active investor? Luckily, it leads right to the actual answer in its last paragraph:

[...]recreational investor is at a severe information disadvantage... [because he or she is] ...at work during the day and will always be late to react to events...

The effort threshold where you can reasonably become an active investor is when you can spend most of your work days "investing". This means you have to quit your other job. This in turn means your investments have to become your main source of income. This last one also determines the capital threshold -- you must have enough capital to provide you with desired income based on your actual rate of investment returns.

Suppose your RoR is 10% (yes, you're lucky and wise), and you need 50 000 currency units per year to live in relative comfort. Subsequently, once you accumulate 500 000 of said currency units, you can become an active investor.

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P.S. Many have commented that it doesn't make sense at all to become an active investor, because one will never outperform <passive investment returns> + <full-time job earnings> + <inflation> + <trading expenses> + <risk adjustment>. This is most likely true, but it makes a lot of assumptions about the investor's motive. This answer attempts to find when you can practically become an active investor, regardless of your motives, not if you should become one.

Answer 4

Does it make sense for someone to pursue being an active investor? Does it only make sense for people that actually have a lot of money or are willing to actually put a LOT of effort?

The simple answer is that for most people it does not make sense. In my view, it does not make sense unless you actually enjoy it, in which case it might make sense if you can build up enough skills to reliably beat the market. But it doesn't make sense to set out to do it specifically to make money.

I agree with other answers that are suggesting that, if you want to analyze it quantitatively, you need to look at the opportunity cost relative to index funds and earning a normal wage. In other words you might want to be an active investor if you could earn more by spending 40 hours week picking stocks than you could by spening 40 hours a week working your normal day job and investing your savings in the S&P 500.

One additional problem, though, is that you probably won't be able to do that initially. So in reality you probably need to spend some time losing money to practice before you get good enough to beat the market (assuming you ever do). In this sense, learning to pick stocks could be thought of as similar to going to law school or apprenticing yourself to a carpenter: you are sacrificing current income (and may even be paying out of your own pocket) in the hope of gaining skills that will increase your income later. However, the path to success is much less clear because you may still wind up unable to beat the market. So perhaps it's more like going to an acting school, where you might graduate and still not be able to make a living doing what you went there to learn to do.

So why do people go to acting school? Because they like it. This to me is the thing that is often missed by focusing on things like your relative return vs. the S&P 500.

Unless you are some kind of one-in-a-billion savant, you're definitely not going to be able to beat the market right away. And even if you try to learn, your chances of success are low. (If you learn from a skilled carpenter you can probably eventually learn to be a carpenter yourself, but there is no comparably reliable and accessible way to become a good stock trader.) And even then you're probably not going to get rich. Very few people get extremely rich by picking stocks to buy with their own money; mostly they get rich either by selling their own stocks (i.e., by founding or being early investors/workers at a company that becomes huge) or by managing other people's money. So even if you pencil out what you theoretically could make by eventually getting good enough to outperform the S&P 500 by X%, it's probably not going to make you super rich, and certainly not overnight.

The only real reason to do something that probably won't work and probably will not make you rich even if it does work is that you derive intangible benefits (such as enjoyment) from the process of doing it. If you like picking stocks and discover you're good at it, it can make sense to gradually put more time into it, develop your talent, and at some point maybe (probably not, but maybe) you'll notice you're making enough money that you could think about quitting your day job.

Again, I think artistic pursuits may be the closest analogy. No one sits there with a calculator creating a 5-year plan to learn guitar in order to make a living as a rock musician --- unless they already like playing music. No one quits their day job and starts writing a novel to make a living as an author --- unless they're internally motivated to write. Similarly, my view is that no one should think about making money from actively trading stocks unless they discover they enjoy it even when they're not making money, but then also discover that they are in fact making money, and decide to try to get better at it.

That's why I think it doesn't make sense for most people. Researching company financials, following stock prices, and/or building quantitative algorithms to guide buy/sell decisions isn't most people's idea of fun. And if it isn't fun, the potential financial rewards simply aren't sufficient to justify the time and expense.

Answer 5

Even if you believe all of modern portfolio theory supporting passive investing, the theory still suggests you should be able to get better returns with a professional management strategy. The reason is that standard indicies (like S&P) are not optimally placed on the risk/return curve at all times. Why should they be?

A professional can try to obtain an even more optimized combinations of assets as well as use leverage. All of that could still be consistent with a passive strategy, of buying and holding broad assets for the long term. Professional management is not the same as day trading.

For an individual investor, an extra percent or two of returns may not be worth the effort. As others have pointed out, you need to make it worth a salary. But if you have several billions of dollars, an extra percent is a lot of salary.

People are forgetting that index/ETF fund investing is supposed to be a GOOD, EASY, and CHEAP way to invest, not that VTI is God's true and only way to make money.

Answer 6

I would like to address the non-answer (hedge funds and institutional) a bit because I think it is important. What I have heard is that there is only an advantage in using hedge funds when you need to diversify your portfolio and you need something that is more independent than an index fund (which tracks the market average). The argument then follows exactly as the argument for investing in index funds. There usually isn't much point in diversifying from index funds unless you already have a lot of money in index funds. If the money sunk purely into an index fund were to outweigh individual stock investment sufficiently, then the fund itself would start to act like an individual stock (increasing volatility) and the way to balance out a portfolio would be to invest in stocks moving independent of the index.

Of course the question asks specifically about active personal investors (not hedge fund managers or institutional investors), in which case, the reasons people still do it are mostly greed and hubris (it is promoted by tons of get rich quick guru scammers selling courses in Forex trading at stupidly high prices and stuff like that). I think other answers have explained quite well just why active trading is usually a bad idea for individual investors and roughly what kind of money is needed ~ (ROI%Active - ROI%Index) * invested_capital > expected_salary, and keep in mind that ROI%Active for some of the legends is only ballpark 20% (Buffet)... so as something like the best trader in the world you would need 12-13% of your investment to be greater than your expected salary (assuming index funds are doing 7-8%). A lot of people smart enough to get that kind of ROI are also smart enough to make quite a lot more than minimum wage in their chosen profession... say 100,000 USD, so a 1.2 million ish investment would be break even if you were a super genius investor. More realistically you might beat the index by 1 or 2 percent (if at all)... so we're talking over 10 million invested for it to be worthwhile to even consider being an active day trader.

I'm baking trading costs and inflation into the ROI terms.