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When is it a stock picker’s market?

By Dr. Don Taylor ·
Thursday, June 26, 2014
Posted: 11 am ET

A few weeks ago I wrote about the myth of sidelined cash -- waiting for the right time to get in the game and buy stocks. Today, I want to talk about a second idea mentioned in that post -- that there are times when it's better to be a stock picker than to passively invest in a market index. I'm indebted once again to Clifford Asness, managing and founding partner of AQR Capital Management, for listing "it's a stock picker's market" as a phrase he would like people to stop using in a Financial Analyst Journal article, "My Top Ten Peeves."

© Ivonne Wierink/Shutterstock.comA stock picker identifies stocks that look cheap and buys them, or that look rich and sells them. Active managers try the same thing with sectors of the stock market, rotating into a sector that seems cheap, or rotating out of one that seems rich or just fully valued. It takes a combination of valuation methods and market timing to make this work. The question becomes, if the investor has this ability to identify rich and cheap stocks, why would he or she abandon this approach to take a more passive one during certain market conditions? If you're good at it, then why go in and out of this approach, based on overall market conditions?

Value investors are stock pickers. There are years when value investors outperform growth-oriented investors, and years when they don't outperform them.

There will always be stocks that go up in down markets, or down in up markets. In general, it happens when a company's prospects differ significantly from the market's prospects. Being able to spot that difference makes value investing work.

Overall the stock market will earn its average return. The passive investor investing in the market index earns that average return, less fees and expenses. Investors that actively manage their portfolio, either on their own or with professional managers, hope to earn a return, net of fees, higher than they would have as passive investors to justify the more expensive portfolio management style. Some will, some won't, but on average they won't beat the market.

That's why I'm a fan of core-satellite investing, where most of your portfolio is invested in low-cost index funds, diversified appropriately, but a portion of the portfolio may be managed actively. Ideally you're only paying higher fees on the satellite portion, reducing drag on the yield of the indexed portion.

How do you manage your portfolio? Do you switch between passive and active management when it's a "stock pickers" market? Do you move into cash when you think things are pricey? What gets you to rebalance your portfolio, or change your asset allocations?

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