Active Versus Passive Investing: Which Style Is Right For You?

After understanding why investments can be scary, hopefully you’ll come to the conclusion that you are comfortable with the concept of investing. I’ll go over two types of strategies related to investing in the stock and bond markets: active and passive. There are people that are very passionate about one strategy versus the other, and this can lead to some heated discussions. What matters is that you understand the basic concepts of these strategies, then you choose a strategy (or mix of strategies) that makes the most sense to you.

STRATEGY #1: ACTIVE INVESTING

Here are some examples of active investing:

1. You pick stocks based on company recognition alone. You love going to Starbucks, so you decide that you’d like to own a part of Starbucks. You’re pretty sure Starbucks is going to be around forever. Not a lot of research went into this method.

2. You do a ton of research. You look at the company’s annual reports, noting their assets, liabilities, and income statement. You keep close tabs on the latest reports and look at the industry as a whole. You then make an informed decision as to whether or not to purchase that company’s stock or a mutual fund (where investors pool their money together). How much to buy and at what point you want to sell is completely up to you. This requires much more time, effort, and interest on your part as an individual.

3. An active portfolio manager is someone who is doing example 2 for a living.  They often times have a whole team of people working with them. Their goal is to give their investors the best returns in the short term, because they will find themselves out of a job if they’re not posting some good numbers. Human decision making + extra fees means that you’re putting an awful lot of trust in these people to beat the market for you (remember, they have to also make up for their fees in order to give you a net positive return).

So as you can see, active investing is where you are constantly attempting to make a profit, or “beat the market”. If you use the S&P 500 as your benchmark and the rate of return is 8%, you want to see if you can do even better. Because why settle for 8% when you could have made many multiples of your initial investment with a single stock?

What we’re dealing with in active investing is that these investors are making their best predictions based on what they think is the best way to beat the market. Value investors, such as Warren Buffett, look for the “good deals” and invest in companies that he thinks are cheap now, but will become more valuable over time. He’s one of the richest people in the world, so obviously he has done well in this department. Other investors like to invest in companies in a particular sector. Still others like to focus on companies that are growing rapidly.

Many of these investors seem to do really well when you look at their numbers. However, the important thing to note is the timeframe– it’s very easy to cherrypick a time period when investments have posted some great numbers. Just look at the past 10 years since the Great Recession- almost every investor that had any money invested in the stock market looks like they’re investing geniuses. Turns out that everyone did well, not just you or whoever manages your money.

If your goal is to beat the market in the short term, then you’ll have no trouble finding examples of active investing that have done a great job. However, this changes when you’re looking at the long term.  To consistently beat the market over the long term has proven to be nearly impossible.

The SPIVA® scorecard releases an annual report that compares active and passive management. When you look at the numbers for long-term investing (past 15 years), well over 90% of the active managers in small cap,  mid cap, and large cap funds actually missed their respective benchmarks. These are people that get paid money to do this for a living. These are the professionals.

WHAT???

When I first started reading about investing, I would come across these types of statistics on a regular basis, and I was honestly shocked. I could understand how your typical day trader picking stocks from his computer at home could fail more often than he succeeds. But how is it possible that these numbers skew so heavily against active management done by professionals?

STRATEGY #2: PASSIVE INVESTING

Passive investing, popularized by Vanguard founder Jack Bogle, assumes that you don’t want to play this game. You’ve got better things to do with your time than study the markets and make your best guess while competing with the professionals. There’s a cost to utilizing these professionals, and once you realize that even the professionals aren’t guaranteed to outperform the market for the long haul, you decide that passive investing is for you.

The easiest thing to do is buy the entire market. Index funds are a type of mutual fund that track a particular class of investments. So if you wanted to buy the whole stock market, you could go with something like a total stock market index fund. If you wanted to focus on just the S&P 500 companies, you would invest in a S&P 500 index fund.

If you own a total stock market fund, you don’t have to beat the market because you’re invested in the whole thing. If the markets keep humming along as they have, then despite the roller coaster ride, you will be better off in the long term. You can eliminate the risk of a money manager making bad decisions and the fees associated with active management. You’re then left with the inherent risk in the stock market and much lower fees (it doesn’t take much effort to track an index versus actively trying to beat a benchmark). The stock market has shown that it will reward you over time if you stick with it through thick and thin. The important thing is that you actually keep your money in the market, even when it goes through its downturns.

This has revolutionized the investing world. It doesn’t make much sense to pursue active investing when studies have shown that passive investing outperforms active investing in the long term. Many people simply don’t have the time, interest, or extra money to pursue an active investment strategy. They just want to be able to invest without being subject to catastrophic losses.  They are willing to take some stock market risk because it’s the simplest method out there, and it has proven to work.

The passive investment strategy aims to just keep up with the market rather than beating it. The returns in the stock market will be the returns that you see on your investments, minus very low fees. This is one example of when you actually want to be average, because average still means that your investments are making money for you.

Even Warren Buffett himself recommends passive management over active for people looking at long term investing, such as for retirement.

WHY NOT 100% PASSIVE INVESTING?

So why doesn’t everyone go into passive investing?

We are all human, and humans are wired to be competitive. There are plenty of people out there that don’t want to settle for ho-hum passive investing. It’s too boring. They thrive on playing this game of beating the market. They are driven by the possibility that they can strike gold if they make the right decisions.

Some people love the data, analysis, and research that would be needed for active management. They love studying the markets. As mentioned earlier, people get paid to do this for a living. If they do well, they get paid very, very handsomely.

And you know what? Sometimes they do succeed. That’s why active investing will never go away. Our financial markets depend on some level of active investing, too. However, what makes sense for the finance industry as a whole doesn’t necessarily make sense for the individual investor.

You also have to remember that this game requires not just skill, but a whole lot of luck. There are instances where it’s all luck- you just happen to buy the right stock at the right time. Think of all those folks that bought Berkshire Hathaway when it was a no-name company, and the only reason they bought it was because a friend of theirs suggested it. That one suggestion made some long time BRK investors multi-millionaires.

It’s all about risks and rewards. You want a bigger reward? Are you aiming for better than expected returns? Then you have to be willing to be riskier with your investments, and you also have to comfortable with the very real potential for bigger losses.

Are you looking for short term gains over long term gains? Again, these are questions that you will need to ask yourself and figure out which strategy makes the most sense.

WHY I CHOSE PASSIVE

After doing my own research, I’ve decided that the passive style suits me much better. I’m a risk averse person in general, so it just made more sense. I’m focused on long-term investing, not making short term gains. The fact that there is actual data showing that passive has beat active over the long haul makes this decision much easier. I just want to save money and invest it in a safe way. Right now, the safest way to do it is through low cost index funds.

I like simple. I like the idea of set it and (mostly) forget it. Passive investing is about as simple as you can get.

LOOKING TOWARDS THE FUTURE

Remember the phrase “past performance does not guarantee future returns”? You’ll see this on any mutual fund prospectus, reminding investors that just because something has done well in the past does not guarantee that it will continue to do well in the future.

I think one can expand this thinking to investing strategies as well. To date, passive investing has outperformed active investing for the long haul. As I mentioned, we have plenty of data supporting this fact. And many people much more savvy than me in the world of investing think that it will be this way forever.

My only pushback is that no one can accurately predict the future. We’re all trying to make sense of the world around us, and we’re all working with the same historical data. Ultimately, we make choices that make us sleep better at night. If the idea of getting market returns through passive investing sounds right to you, then go with that method. If you like the more hands-on approach to investing and you’re convinced that active is the way to go, I’m pretty sure whatever I say isn’t going to make a difference. Only time will tell which method was better for you.

CONCLUSION

The world of investing can be complicated. Active investing used to be the only way to invest. Jack Bogle and the introduction to passive investing with index funds has allowed investors a chance to simplify their investments, especially individual investors like you and me.

Also remember that this isn’t an either/or situation. One does not have to use 100% of either strategy. Plenty of people do a combination, depending on their individual circumstances and preferences. For example, you could have a portfolio of mostly index funds and devote a certain percentage to individual stocks.

Finding your investment style is crucial to creating your very own portfolio and coming up with a plan. Don’t underestimate the power of connecting with your investment style.

Are you Team Active or Team Passive? Why? Comment below!