Active management shapes entrepreneurial conviction

The key to long-term investing is believing in what you own

I’m about to tell you a secret about investing, and it might surprise you based on the marketing material and propaganda you’ve been subject to over the years.

There is no right way to invest.

There is no strategy that guarantees success.

What works for someone else might not work for you at all.

Remember when I said conviction is the key? Well, the best strategy for you is the one you will have the most conviction in.

Note that I didn’t say the best strategy is the one that will outperform. Or the one that will have the highest risk-adjusted return. Or the one that costs the least. All of these are noble objectives to pursue in building a portfolio, but without your conviction, they are not right for you.

There’s a saying among professional investors—“you can’t borrow conviction.” The idea is that I can steal stock picks from anyone, but I can’t steal their conviction in the investment. So if you follow a respected manager into a particular stock, you have to be aware that you won’t know when they decide to sell, or if their opinion has changed. If things turn south (which they inevitably will at some point), you must have your own conviction in order to decide to hold on, or to buy more. If the facts change (which they will), you alone need to know how this shapes your confidence in the investment and whether it’s time to change your thesis.

The same applies to the wealth manager you hire—how well do you understand their strategy? How confident are you in it? Let’s exercise some premeditatio malorum and decide if this is a strategy we are willing to ride out when the going gets tough.

Most people I’ve worked with over the years—entrepreneurs and professionals—simply don’t understand academic finance–based strategies. How do I know that? Because I’ve been doing this for over two decades, and I’ve talked to people who shrug at the various passive and academic based funds in their portfolios.

And I don’t blame them! I often zone out when researchers start droning on about factors and explaining derivations of formulas. I have a hard time believing that people with no formal finance training care to take the time necessary to truly understand how their portfolio is being built.

So it all comes down to your advisor saying “trust me.” And trusting your advisor isn’t a bad thing (as long as you’re trusting the right person). The problem comes when your investment performance starts to sag, and you start to wonder if you’re in the right strategies with the right advisor, and you suddenly realize you don’t really understand what’s in those funds in your portfolio. And so what happens is that your faith is shaken at the exact worst time. When your portfolio is down and forward-looking potential returns are at their highest, you sell. As illustrated in the famous Dalbar study, it’s a recipe for long-term underperformance. And it’s a tragically common tale. Every advisor will tell you that their phone starts ringing during and after a market decline, when investors lose confidence in their current advisors and portfolios.

If you don’t understand something, you can’t have conviction in it. It will be that much harder to hold on when you need to.

The index that I bought several years, or decades, ago, is not the same any more. The constituents have changed. The largest companies in the index have changed. What I bought that may have once been dominated by conservative health care and financial companies might today be mostly driven by the performance of high-flying technology shares trading at stratospheric valuations. The index itself may have become more volatile and risky over time.

When I need to buy more, am I ready to do so? Or is there something in the back of my mind making me question what I’m invested in? Is it possible that I own a shitty index? Can I trust this anonymous committee’s decisions?

On the other hand, if I own an actively managed portfolio, I can see the names of the companies I’m invested in. I can talk to the portfolio manager about what we own and why we own it. I can gain some reassurance that my largest holdings can survive a prolonged recession, that their balance sheets are strong, and, in fact, that they stand to gain market share against weaker competitors, regardless of market conditions.

Now I have conviction. And now I can gain the confidence to hold on at the bottom. I can gain the confidence to allocate more to equities when things look their most bleak.

This is why I believe in active management. Not because of an expectation to outperform a passive benchmark—there is no guarantee of that. I believe in active management because it is the best way I know for an investor—particularly an entrepreneurial investor—to gain the conviction they need to stick with their plan when it’s hardest to do so.

I’m not saying that having an active manager is the only way an investor can have conviction in their portfolio. But I am saying that, in my experience, for the vast majority of people it’s the best way for an investor to have conviction in their portfolio.

Why do I say this?

I work with many people who have created their wealth by building (and often selling) a business. The academic finance crew might say that it’s “optimal” to put your money in a passive, factor-weighted portfolio, but in my experience most people appreciate knowing that their investment strategy is built on the foundation of owning businesses—it’s how they built their wealth. But just owning baskets of hundreds or thousands of businesses doesn’t necessarily resonate. And so I find that it’s harder for entrepreneurs to gain conviction in passive strategies.

If the stock market is down 40 percent, I might be really nervous about the performance of my XYZCo AlphaOmega Small-Mid-Large Cap Value-Growth ETF, even if it’s down only 30 percent. But if my shares of Johnson & Johnson are down 30 percent, I’m more likely to stick with the plan, and, in fact, even buy more shares. Because I know that J&J ain’t going anywhere.

Without conviction, the market will shake you out of your investments at the worst possible time.