Is there a place for active management?

There is a place for active fund management but it's not what you think it is and it is not the way you think it works:

A passive investor does only certain things. Straying from it invites considerable risk.

An active investor must do everything a passive investor does and when he does something different it is only after bringing a great deal of intelligent effort.

Intelligent effort is characterised by having the right mental framework for decision making, skill, considerable experience, tested judgement and more then a trace of wisdom.

In most years he will do no better then the passive investor but every now an again the active effort will pay off. Over large amounts of time the additional gains add up.

"The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor." Ben Graham in "

The Intelligent Investor", 1949.

Background:
The failure of mutual funds to beat the Indexes. Ponzy schemes that emerged during the credit crisis. The outlandish fees that were charged by Hedge funds while producing little benefit over index returns. All these issues have sewn the thread of doubt in active investment management.

If you do all the right things, will you get outstanding results?

Not necessarily.

Although competence and hard work are necessary, luck is essential

You will probably, however, not get a bad result.

Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock market folly that prevail during your investing career

Warren Buffet, preface to the fourth edition of the Intelligent Investor

I might add to Buffet's quote the fact that you have to be able to take advantage of a market folly.

If you develop all the right attributes, will decision making become easy?

Not necessarily. There is one other ingredient, Courage.

Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right, Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Benjamin Graham from the Intelligent Investor

Warren Buffett has called derivatives "weapons of mass financial destruction" but then he went and wrote a whole bunch of derivative contracts. Is he being disingenuous?

On the surface the answer is yes. If you look at it from the point of view of the 'margin of safety', the concept Buffett learned from Benjamin Graham, the answer is no.

The derivative positions are "put options" on at least three world wide Indexes. This means that for an up front fee, Berkshire will pay out a very large sum of money, many years from now on a particular day, if the indexes are below a specific value on that day. That specific value is called a strike value. Unlike the derivative contracts written by AIG there is no requirement to post a collateral if the "mark to market" value varies which almost surely it will. Collateral in finance means a security or guarantee (usually an asset) pledged for the repayment of a loan. In this case it's cash. The term "mark to market" means the contract is given a value daily even thou the contract matures many years from now. Having to payout a collateral pushed AIG into bankruptcy.

Furthermore, to completely lose all the money, all three indexes would have to go to zero. It just won't happen.

All these factors : 1. the lack of collateral required 2. the time to maturity 3. multiple indexes 4. the choice of indexes 5. the up front fee all constitute a "margin of safety".There is one other "margin of safety" not so obvious and that is of a manager that has both the experience and good judgment backed by a sound mental framework for decision making.

Perhaps the analogy is the use of explosives. If used without skill, experience and good judgment, it could blow up in your face. But used with skill and only in selected situations such as demolition it is the only solution.