Tuesday, June 21, 2016

An equity world of extremes - the need for active management?

This is a very interesting chart on equity performance. Obviously, the histogram will be affected by the size of the buckets but it does not change the fact that there is significant performance action in the tails of the distribution. There will be big winners and big losers in the long-run. Passive management will generally not be able to take advantage of these extremes. Granted that market cap weighted indices will have grater weight to high performers over time, but market divergences will not be captured through passive management.

One of the reasons for the effectiveness of momentum investing is the movement to extremes. Divergences do occur. If you think that stocks will converge or mean-evert to some long-term market average you would not have fully participated in the equities that showed upside. Similarly, if you would have held onto stocks that continued to decline under the hope that they would mean-revert, you would have been gravely disappointed. Market dislocations are a key part of investing, so accepting market divergences will be helpful in the long-run.

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