Trading on developing market trends will get investors in late and out too soon. That’s not active investing. It’s reactive trading. Your clients aren’t interested in becoming day traders. They want to see their portfolios grow over time and have confidence that retirement will be a pleasant time in their lives, not a scramble to make ends meet.
The line has been understandably blurred with all the volatility the market has gone through this year. Passive investors are still sticking to their models, despite epic losses in historically reliable market sectors. Panic selling and impulse buying have been rampant in the retail investor space. Active investing doesn’t garner much attention amid all the noise.
Blending Technical and Fundamental Analysis
Tracking price swings in the market using stochastic indicators and resistance bands is called technical analysis. Looking at economic and financial factors that influence businesses in certain sectors is known as fundamental analysis. Active investors use both. Passive investors rely on historical data to predict future market movement.
Day traders use technical analysis to track short-term price swings and make trades within hours or even minutes of each other. Buying and selling on flags and pennants is not investing. For wealth managers, that would be like taking your clients to the casino and handing them a stack of chips to gamble with. We’re betting that’s not what they’re paying you for.
Reactive Trading is How We Got Here
Based on the market cap to GDP ratio, the market is currently overvalued by 77%. Some of that is due to GDP falling during the pandemic and post-pandemic years, but the trend started long before that. According to Investopedia, overvaluation happens when you have “an uptick in emotional trading, or illogical, gut-driven decisions that artificially inflate stock prices.”
During the heart of the 2020 pandemic, retail traders accounted for 25% of all the trades made in the stock market. That group included your eccentric Aunt Bea on Robinhood and crazy Uncle Alvin who subscribes to Reddit. Emotional and illogical trading was at an all-time high when folks were stuck at home that summer. It’s no wonder that the market is overvalued.
Of course, we can’t exonerate the institutional investors in this mess. The “Reddit Raiders” weren’t the only party that made money on the GameStop squeeze. Institutional money will almost always follow retail money if the gains are big enough. Between that and SPACs setting outrageous IPO prices during the market surge of 2021, we have arrived at a correction point.
Active Investing is a Process, not a Panacea
Have you ever tried one of those “miracle” weight loss programs that claims you’ll drop thirty pounds virtually overnight? They don’t work. Losing weight and keeping it off requires hard work and dedication to diet, exercise, and a lifestyle change. Active investing is like that. It’s not a panacea that will instantly restore your portfolio after years of losses.
Active investing is not an “anti-model” investment philosophy. Tactical models work because they have the flexibility for changes as economic circumstances evolve. That’s why we call what we do “tactive investing.” Passive models are static. In this market, many clients with passive models are watching their retirement funds fade away with little or no option to restore them.
Making the right investments for long-term growth is a process. The market is always changing, so it’s important to be able to adapt. That doesn’t mean eliminating ETFs from the portfolio or avoiding entire sectors showing losses. There’s always a diamond in the rough. Active investors use technical and fundamental analysis to find out where it is.
It’s Okay to Change Your Mind
This word “change” sums up what active investing is all about. On November 12, 2021, Netflix (NFLX) hit an all-time high of $682.61. Nine months later, on August 23rd of this year, they opened at $226.74. Forbes profiled them in an article that morning as the “worst performing stock of 2022.” That’s how quickly the market can turn.
The origin story of Netflix is an iconic tale told in most business schools. In 2000, Netflix co-founder Marc Rudolph approached John Antioco, CEO of Blockbuster Video, with an offer to sell his company. He was basically laughed out of the office. Ten years later, Blockbuster filed for bankruptcy, and Netflix had a market cap of $10 billion. That was a significant number in 2010.
Nostalgia might induce some investors to hold off on selling Netflix because they are the ultimate David vs. Goliath story. There might even be a passive model or two that still includes them. Will Netflix rebound? It’s possible, but that doesn’t mean you should keep taking losses. It’s okay to change your mind. That’s one of the cornerstone principles of active investing.
Putting it all Together for Smarter Portfolios
Let’s stick with Netflix for the moment. The water cooler crowd, if there is such a thing anymore, would say that the company is “falling behind” its competitors. They’ll reference their favorite shows on Amazon Prime or the new “Game of Thrones” prequel on HBO Max as reasons for the decline in Netflix share prices. As usual, the “cooler crowd” is misinformed.
Netflix was overvalued. They posted $1.7 billion in net income for Q1 this year with a 25% margin, yet still lost 60% of their share value in nine months. That has nothing to do with programming. The price spike back in 2021 was an anomaly. Active traders saw that and sold the stock. Now that it’s bottoming out, maybe it’s time to buy it again.
Overvaluation and correction are common themes in 2022. The trick to getting through that is to sell at the peak and buy back in at the trough, if the company is worth investing in. That last part is what separates active investing from reactive trading. The technical charts show the price fluctuations. Fundamental analysis is how buy/sell decisions are made.