Fundamentals of Portfolio Investment. Part 2

Jeremy Stone Investments Read 5min

So, in modern markets, owing to the growth of their effectiveness, it becomes immensely difficult to gain a stable income above the market. I don’t mean to say it is impossible. Still, this will require you to be a cut above other market participants by qualification so that you can capitalize on the inefficiency created by other market participants.

Fundamentals of Portfolio Investment. Part 2 1


Do you want to take an example from Buffett? To begin with, I recommend that you take an interest in his biography (I like this one — “The Snowball”) and find out how much time he spent on studying the reporting of companies.

During one television show, the presenter asked Buffett to give advice to novice investors. “Do what I did in my youth: study every company in the USA that has public securities; it will serve you well over time,” Buffett replied. “But there are 27 thousand public companies in the USA,” the presenter raised his eyebrows in surprise. “Start with the letter A,” followed Buffett’s answer.

If you are trying to engage in active investment (or, moreover, speculations) without due regard, you’ll be losing your money. Statistics say that even the vast majority of professional (!) managers (for example, managers of mutual funds) are defeated by stock indices on long periods of time. You can find many examples of such statistics in books by John Bogle, Burton G. Malkiel, William J. Bernstein, Jeremy Siegel, Jason Zweig …

A great many people go to financial markets in an attempt to beat them, because this is usually what they learn from books by investors like Graham, Buffett and Lynch, and speculators like Livermore, Baruch and Soros. Not to mention articles in the media and numerous investment-oriented Internet sites. So people go to financial markets, hoping to repeat the success of Buffett or Soros.

What’s so bad about it? Nothing bad. However, there is a problem. If you play on the same board according to the same rules with Buffett or Soros, hoping to repeat their results, you can succeed in this game only provided you are better than them. And they are, I remind you, professionals. Answer the question: are you ready to engage in investment or speculation professionally, like buffetts and soroses do? Are you willing to give a significant part of your life to this occupation? If so, then go ahead! If you are ambitious and want to choose professional investment or speculation as the business of your life, I will not discourage you from that.

Yet, most people are not ready for it, they don’t seek to understand financial matters professionally. People earn money in another way — by working as teachers, doctors, office clerks, sellers, drivers, housewives and so forth, as well as engaging in some business, achieving success in the world of sports, art or science. In most cases, these people are not going to earn billions in investments by beating Buffett or Soros in the financial markets. They need simple and understandable ways to increase their savings without undue risk.

Are there such ways? Yes, there are.

For that you need to set a task different from the one set by active investors or speculators.

Instead of trying to “surpass the market”, a passive investor accepts as an axiom the assertion that it is impossible to constantly beat the market, so it is not worth wasting time on. Therefore, he consciously refuses such a statement and sets himself another task — “not to lose to the market”. His strategy is to get average market results (plus, perhaps, to beat it if he is lucky) without spending a lot of time and effort on it.

The difference between an active and a passive investor was first determined by Benjamin Graham. The first edition of his book “The Intelligent Investor” was published in 1949, and I recommend it as the main book for an investor.

A passive (or defensive) investor chiefly seeks to avoid serious mistakes or losses. His second goal is to be free from the need of making decisions often.

The defining feature of an active (enterprising, aggressive) investor is the desire to devote his time and efforts to choosing more attractive securities. For many decades, an active investor of this kind could expect a worthy reward for his additional skills and efforts in the form of a higher average income than a passive investor’s.

Benjamin Graham

Fundamentals of Portfolio Investment. Part 2 2

Graham himself was an active investor, not a passive one, but he identified in his book some of the passive investment beginnings as far back as 1949, even before the publication of the works by Markowitz.

Yes, an active investor has the opportunity to increase the return of his capital, as Graham and his successful learner Buffett did. And, as a remuneration for his labors, he will receive a profitability significantly higher than the market. Still, before embarking on this path, I once again suggest that you answer the question: are you ready for the efforts this will require?

Another quote by Graham:

An aggressive investor should be versed in the value of securities so well that his operations with them can be considered his business (…) It follows that it is better for most securities holders to choose a defensive strategy.

Most investors don’t have the time, or the determination, or the intellectual inclinations to conduct such a business. Thus, they should be content with a moderately high profitability available for owners of passive portfolios, and deal with the recurring temptation to turn from this path in search of higher profits.

Benjamin Graham

By the way, Buffett gives novice investors similar advice. The quote below refers to index funds; however, it can be successfully attributed to passive investments in a broader sense of the term (actually, passive investments are not limited to investments in index funds, there are many interesting ideas about which we will talk further).

Even an incompetent investor will be able to surpass the achievements of most investment professionals if he periodically invests in index funds. This is paradoxical, but when ‘stupid money’ acknowledges its limitations, it ceases to be stupid.”

For most investors, both institutional and private, the best way to hold securities is to participate in index funds at minimal cost. Those who will go this route are sure to get higher returns (after costs and fees) than the vast majority of investment professionals.”

Warren Buffett

Fundamentals of Portfolio Investment. Part 2 3

You want more quotes? Here:

I came to the conclusion that active portfolio management is a game for greenhorns.”

William J. Bernstein, “The Intelligent Asset Allocator

The market is so effective at setting the price of shares that even blindfolded chimpanzees, at random throwing darts in the Wall Street Journal, can form an investment portfolio that will be no worse than made up by professional managers.”

Burton G. Malkiel, “A Random Walk Down Wall Street

There is a deep conflict of interests between those who work in the investment business and those who invest in stocks and bonds. The path to the welfare of the former is to convince customers: “Don’t sit back, do something.” But the latter, in order to increase their well-being, must follow the opposite rule: “Do nothing. Sit back.” This is the only way to avoid a game obviously doomed to failure — attempts to outplay the market.”

John Bogle, “The Little Book of Common Sense Investing

Investing should be boring. It doesn’t have to be exciting. It should be like observing drying paint or growing grass. If you want an exciting experience, then take 800 dollars and travel to Las Vegas.”

Paul Samuelson, “The Ultimate Guide to Indexing

I guess that many of you are now very surprised to compare these quotes with the information that you previously encountered before.

Well, this once again proves the imperfection of the information field around investments, which is currently prevailing in Russia. Such an information field has understandable beneficiaries. First of all, these are brokerage companies interested in increasing your active operations in the markets (with you paying commissions for brokerage services), and management companies interested in attracting your money to active management (with you paying them management fees). As well as many indirect beneficiaries, such as various financial media (television, radio, newspapers and magazines, the Internet) living on advertising revenue from the businesses mentioned above.

To find among this informational noise the information allowing you to build in your head an adequate picture of what is happening in the financial markets will be very difficult!

So, a passive investor refuses the idea of “getting ahead” of markets, both through market timing and speculation, and through the selection of separate stocks — active investments. Instead, he invests into the market as such.

As I already wrote, you can be a successful passive investor, you can (although much more difficult) be a successful active investor, and a very small number of market participants manage to be even successful speculators. However, it is strongly discouraged to mix these approaches. It is the lack of understanding of what exactly you are doing in the market that will quickly lead you to the fourth group — players, “dummies” and inexperienced investors who, as a rule, lose money in the market (while, as in any gambling, there might be temporary random winnings, which anyway in the end, as a rule, lead to a drain of money).

You can read about the differences in strategies in “The Intelligent Investor” by Graham, and today I will very briefly, abstractly draw your attention to the differences between various strategies. I note that the classification below is not strict, there may be exceptions, but it conveys the basic ideas and differences of all three approaches from each other quite correctly.

Knowledge and experience:

  • Speculations — required
  • Active investments — required
  • Passive investments — minimal

Both successful speculative actions in the market and successful active investments require knowledge and experience. You will not become a successful speculator or a successful active investor only after reading several books and listening to a couple of seminars. To surpass other market participants, you will need months and years of hard work, gaining knowledge, “cones” and experience. If you are not ready for this, you’d better not do these types of investments at all.

But the task “not to lose to the market”, which is solved by a passive investor, requires much less effort; it does not require much experience or high qualification. My practice shows that a few hours during a one-day seminar or several webinar classes are enough to start successfully applying portfolio investment strategies right after that.

Time spent:

  • Speculations — high
  • Active investments — high
  • Passive investments — minimal

For a speculator, the time spent is very high. In essence, professional speculation is work.

The time spent by an active investor is usually also high. The active investor rarely carries out the operations himself; however, time-consuming procedures such as data collection and processing take a lot of time. We don’t yet have good databases on the results of issuers in Russia; large volumes of information have to be pulled out, systematized and processed manually.

Once I asked a question to one of our leading professional analysts (the head of the analytical department at one of the leading investment companies): how long does the average analysis of one issuer take? The answer was “about a week.” If you are planning to engage in active investments and an independent analysis of issuers’ reports, think about whether you can afford it in terms of time.

By the way, I myself apply fundamental analysis, and part of my portfolio is formed according to the principles of active investment. But you should not forget that for eight years I haven’t been working for anyone, I have much more free time than most of you, and I can afford it.

For a passive investor, the time spent is minimal — no more than a few hours a year. In this case, the rest of the time you not only don’t conduct operations, but you can not observe the market at all, not read newspapers and not watch RBC television channel. And, nevertheless, successfully invest.

Source of profit:

  • Speculations — money of other market participants
  • Active investments — income of individual enterprises
  • Passive investments — the economy as a whole

One of the most important questions: where will the money you want come from?

The source of profit for the speculator is the money of other market participants. A speculator is a person trying to take money from other speculators or other market participants. (This statement does not carry absolutely any moral assessments, however, it provides an adequate assessment of your chances of success.) To do this, you must have qualifications that significantly exceed those of other market participants. This is about the same as playing chess for money with Kasparov, going into the ring against Klitschko, or racing with Schumacher. If you are ready to perform at this level — go ahead! If you are not ready, then just become cannon fodder for more experienced colleagues.

The source of profit for an active investor is the income of specific enterprises in whose securities he invests. This income can be in the form of dividends or coupon payments, or it can be in the form of an increase in the value of securities. In any case, the source of profit of an active investor is the profit from the business of specific companies behind their securities — stocks and bonds.

For a passive investor, the source of profit is the economy as a whole. The economy of individual countries, or, even better, the global economy, if capital allows you to diversify into regions of the world.

A source of information:

  • Speculations — prices and volumes of exchange transactions
  • Active investments — balance sheets and reports of enterprises
  • Passive investments — shares of assets in the portfolio

The source of information for speculators is the prices and volumes of exchange transactions, usually in the form of charts, with the support and resistance levels plotted on these charts, as well as technical indicators, which are also calculated on the basis of prices and volumes.

The source of information for active investors is the balance sheets and reports of enterprises.

Passive investors (in the simplest, classic version) are only interested in the shares of assets in their portfolio. And that’s it. A passive investor may not follow markets and economies at all, being only interested in the state of his own portfolio.

This, of course, is the ideal option that many people want to try to improve the results of passive investments through the use of separate approaches from the world of active investments. This is possible, and in the latest versions of portfolio formation webinars, I took a separate day on which I told you how a passive investor could try to improve his results by observing the processes occurring in the markets. But again, this does not come down to either daily analysis of charts or reading newspapers and watching RBC news. It is quite possible to be interested in this no more than once a month or quarter, and at the same time keep the situation under control.

Expected return:

  • Speculations — far above market
  • Active investments — slightly above the market
  • Passive investments — market level

If you ask the speculator about the expected profitability, then in response you are likely to hear a figure that is seriously higher than the average market profitability. You need to understand that this yield is exclusively theoretical, desired. The speculator, as a rule, expects a lot, but the majority, as a result, don’t get what they count on. Instead, they lose money and leave the market.

Profitability of an active investor is slightly higher than the market. I think many of you will be surprised to learn that the average yield of the Berkshire Hathaway Buffett Fund for the period 1965–2010 was “only” 20.2% per annum. Yet, it is enough for Buffett to be the richest investor in the world. On the other hand, the US stock market (as a broad S&P500 index taking into account dividends and their reinvestment) for the same period showed a yield of 9.4% per annum. That is, an average of 10% per year, Buffett beat the market.

Think about it when speculators tell you their tales about 50% per annum, 100% per annum, 200% per annum and so on.

The income of a passive investor is on average at the market level. In some cases, it may be higher than the market (and in the next articles of the cycle we will talk about this in detail), but this excess over the average market figures is not guaranteed.

Transaction frequency:

  • Speculations — high
  • Active investments — several transactions per year
  • Passive investments — several transactions per year

The frequency of transactions of the speculator is high, from several transactions per day to several transactions per month. For certain categories of speculators, it is even up to several transactions per minute.

The frequency of transactions of an active investor is usually no more than a few transactions per year. But I bring out once again that the procedure for collecting, analyzing and processing information on the issuer is very time-consuming for an active investor.

A passive investor conducts no more than a few transactions a year.

Holding a position:

  • Speculations — from seconds to months
  • Active investments — as long as possible
  • Passive investments — several years with adjustments

In speculations, the period of holding a position is from several seconds to several months.

An active investor holds a position for as long as possible. As Buffett likes to say, “my favorite term in stock ownership is forever.” It doesn’t mean an active investor does not sell at all, but his guidelines are such.

The term of holding a position by a passive investor is several years with regular (usually annual) adjustments. Passive investments are optimal if you intend to invest for a period of 3–5, or, even better, 10 years, or until retirement, until the end of your life. Focusing on eternity is no necessary; an investment horizon of several years is enough. On the other hand, I note right away that passive investments are contraindicated for those whose investment term obviously does not exceed 1–2 years. In this case, it is better for a novice investor to simply deposit money in a reliable bank.


Fundamentals of Portfolio Investment. Part 2 4

  • Speculations — usually not used
  • Active investments — limited use
  • Passive investments — strictly required

Most speculators usually trade in a small number of their favorite instruments, and do not use diversification as a defense tool.

Active investors make limited use of diversification. Buffett calls diversification “protection against your ignorance,” and believes that if you are not ready to invest a significant share of your capital in a particular enterprise, you should not invest in it at all. Nevertheless, the portfolio of Buffett himself, basically, is quite diversified: it includes at least several dozen issuers. Though this is probably a consequence of a huge amount of capital, when it is physically impossible to keep money in the capital of only a few issuers.

For passive investors, diversification is strictly required and is one of the basic principles of investment.

Stop orders:

  • Speculation — required
  • Active investments — not used
  • Passive investments — not used

If you intend to engage in active or passive investments, please forget about stop orders altogether. This is a tool for the speculator, and for him it is vital. But neither an active nor a passive investor will ever leave a position just because the price has fallen. On the contrary, often it is a good reason to buy more, but, of course, not automatically — only after a thorough analysis.


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