The Coffee Can Portfolio: An Actively Passive Strategy

The Coffee Can Portfolio is a wonderful article written by Robert Kirby. We can all learn many things by reading it.

Here is what I learnt:

1. In the total, active managers cannot outperform a passive strategy. There are managers who outperform the index and managers than underperform the index consistently.

2. To beat the market is not easy. You need a good investment manager, patience, courage and perspective, all of which are in short supply. Therefore most people and institutions are better off investing in index funds.

3. The wrong reason for investing in an index fund is to get superior performance.

4. The right logical reasons for investing in an index fund are:(although Kirby does not agree with these)

  • Markets are efficient and so it is impossible to outperform them
  • The underperformance of active managers is due to transaction costs

5. The S&P 500 index fund is not a passive strategy because:

  • There is some turnover in the S&P 500. It is not zero
  • The stocks in the S&P 500 change regularly. In that sense it is an active fund.

6. If you want to adopt a purely passive strategy you have two options:

  • The first option is to buy a total stock market index fund that replicates the Wilshire 5000( for those who believe the market is efficient and want to replicate the market)
  • The second option is what we call an actively passive strategy.( for those who believe transaction costs are what decreases returns)

7. The actively passive strategy is called The Coffee Can Portfolio Strategy:

The principle behind this strategy is to decrease transaction costs, administrative costs and all other costs. The aim is to  select  a diversified portfolio of stocks with the knowledge  that the portfolio will not be re-evaluated or re-examined for at least 10 years. The success of the program depended entirely on the wisdom and fore-sight used to select the stocks in the first instance.

The greatest premium that any money manager can hope to achieve over the S&P 500 over 10 years or more is not more than 3% and generally in the range of 2%. Transaction costs eat away most or all of this premium. If we can get rid of the transaction costs, then we have a good chance of outperforming the market.

We have to start with sound research that identifies attractive companies in promising industries on a longer term time horizon. Then we should stop trading those stocks two or three times a year based on month-to-month news developments and rumors of all shapes and sizes.

The basic principle is simple. For example we buy 50 stocks we think are good stocks. We therefore invest 2% of our capital in each of them. We then forget about them for at least the next 10 years. The most we can lose in each holding is 2%. The gain from each holding is unlimited, as we would not rebalance based on  excess profit or loss, diversification or excess exposure to a given company or industry. We just let nature take its course. We don’t cut our winners or ride our losers.

But what we do today is short-term trading and not investing. We produce high turnover. We produce high transaction costs. We decrease our returns. Institutional investing also rewards short-term investing and not long-term investing and they are constantly measured by the profits they make over the short run.

The Coffee Can portfolio approach that is summarised below has a good chance of outperforming the market over the long run.

Choose a group of stocks that have good business characteristics. Buy equal amounts of these stocks(30-50). Then forget about them for the next ten years. No selling, no trading. This is the Coffee-Can portfolio. If you have more money to buy, then buy stocks you think have good characteristics. Then forget about them.

You can read the full article here : The Coffee Can Portfolio