Blog 2: Navigating the Mechanics of Active Investing

Let’s delve into the structured domain of active investing. To begin, it’s essential to outline the primary avenues through which investors seek to generate alpha—returns in excess of a benchmark or peer group. While the investment landscape offers a multitude of decision points, many are notoriously difficult to execute successfully. Fortunately, participation in some of these decisions is optional. However, certain active choices—particularly asset allocation—are unavoidable.

Broadly speaking, investors can attempt to add value through three key dimensions:

  1. Asset Allocation – determining the optimal mix of asset classes
  2. Market Timing – adjusting exposures based on macroeconomic or market signals
  3. Security Selection – identifying outperforming securities within an asset class

Let’s examine each in turn.

Asset Allocation

Asset allocation is the foundational decision in portfolio construction. Abstracting from the broader household balance sheet (e.g., real estate and liabilities), this involves determining the proportion of capital allocated to public equitiesversus fixed income instruments.

Alternative asset classes—such as commodities, gold (a real asset), private equity, and private credit—are increasingly accessible to retail investors. Gold has recently demonstrated strong performance, while commodities are once again being promoted as diversifiers, echoing the pre-GFC enthusiasm around a “commodity supercycle.” Private markets, once the domain of institutional investors, are now being democratized—often a contrarian signal.

Empirical evidence suggests that asset allocation drives the majority of long-term portfolio returns. Equities have delivered robust performance over the past two decades, while fixed income benefited from a secular decline in interest rates—until the recent reversal in yield regimes.

From a strategic standpoint, I advocate for a high equity allocation. Commodities typically require derivative exposure, which introduces negative carry and roll costs. Private equity and credit are illiquid and, in today’s environment, offer diminished return premia due to increased competition and higher financing costs. Gold may serve as a hedge, but entering after a rally often results in suboptimal timing.

In sum, asset allocation is both critical and complex. It’s a domain where institutional and retail investors alike continuously seek an edge.

Once a strategic allocation is established, investors may engage in tactical shifts—adjusting weights based on short-term market conditions. This brings us to market timing.

Market Timing

Market timing involves reallocating capital in anticipation of regime shifts—moving from low-risk to high-risk assetsahead of a rally, and vice versa during drawdowns.

Consistent success in timing markets is rare. Even global macro hedge funds, which specialize in this domain, struggle to maintain hit rates above 50%. The space is saturated, and signal extraction is noisy.

Importantly, market timing is discretionary. Unlike asset allocation, which must be addressed, investors can opt out of timing decisions. Common passive approaches include lump-sum investing upon receipt of capital and dollar-cost averaging through periodic contributions—both predicated on the belief that timing is a low-probability endeavor.

Security Selection

Security selection is arguably the most competitive segment of active investing. It entails analyzing valuation metrics, technical indicators, fundamental data, and qualitative factors to identify securities with potential for outperformance.

The market is highly efficient at incorporating new information, particularly in large-cap equities. The allure of outsized returns—e.g., identifying the next Nvidia—draws significant attention and capital. A compelling narrative around a stock idea can quickly catalyze investor interest and informal due diligence.

For those seeking to avoid this complexity, passive vehicles such as ETFs offer broad exposure without the need for security-level analysis. The growth in ETF assets under management reflects a widespread preference for this approach, especially among non-professional investors. Nonetheless, even passive investors often hold individual stocks, underscoring the psychological appeal of stock picking.

Conclusion

To summarize, portfolio performance can be influenced across three dimensions: asset allocation, market timing, and security selection. Asset allocation is non-negotiable. Passive approaches include a 60/40 equity/fixed income split or market-cap-weighted allocations. Market timing and security selection, however, are optional—and often best avoided by those without a clear edge.

The key takeaway: invest, and do so primarily through passive strategies. Indecision is more costly than imperfect decisions.

This blog will not focus on asset allocation—my preferred mix is 90% equities, and I’ll elaborate on that rationale in future posts. Nor will it emphasize market timing, except to note that elevated risk environments warrant caution and reduced exposure.

We will, however, engage in selective security analysis—not for speculative stock picking, but to understand the underlying instruments relevant to our strategy. Some degree of due diligence is necessary, though this won’t be a forum for buy-and-hold equity selection.

The above topic is related to the following set of topics: