ACTIVE Investing vs. PASSIVE Investing: Is one strategy truly better over the other? [Wednesdays: The Independent Investor]
Miles Everson’s Business Builder Daily speaks to the heart of what great marketers, business leaders, and other professionals need to succeed in advertising, communications, managing their investments, career strategy, and more.
A Note from Miles Everson:
Happy mid-week, everyone!
We hope you’re having a great day.
Let’s start this day with some basic investing tips. Every Wednesday, we write about these topics with hopes that our articles can help you get on the path towards true financial freedom.
In this article, we’ll continue our topic about the fourth discipline of some of the world’s greatest investors.
Keep reading to know the difference between these types of investing and which type of security fits your lifestyle.
Miles Everson
CEO, MBO Partners
Chairman of the Advisory Board, The I Institute
The Independent Investor
In a past “The Independent Investor” article, we discussed the fourth discipline of some of the giants of investing:
Buying the SECURITIES that fit your lifestyle.
In that article, we explained that there are thousands of securities you can choose from. However, to succeed in your investing strategies, you don’t need to know or memorize all kinds of securities in the world.
You just need to recognize your limitations as an investor and keep your securities as simple as your understanding of them. Doing these will enable you to make the most out of your assets.
We’ll continue on this topic by looking at another angle. Since this is part of the disciplines of the world’s greatest investors, it’s important that we understand its subtopics to properly apply it in investing.
Our focus for today’s article?
ACTIVE and PASSIVE investing!
Photo from RBC Direct Investing – Royal Bank
Discussions about active investing versus passive investing sometimes turn into a heated debate because some investors and wealth managers tend to favor one strategy over the other.
While passive investing is currently more popular for many investors, there are still points to be made for the benefits of active investing.
Let’s take a look at the differences between these two…
Active Investing
As its name implies, active investing takes a hands-on approach and involves an analyst or trader identifying an undervalued stock, purchasing it, and using it to maximize wealth.
The goal of active money management is to beat the stock market’s average returns and take advantage of short-term price fluctuations. This requires analysis, insight, and knowledge of the stock market to know when to pivot into or out of a particular stock, bond, or asset.
Active investing has its advantages and disadvantages:
Advantages
- It offers flexibility to investors and financial managers because they aren’t required to follow a specific index.
- It helps financial advisors tailor tax management strategies to individual investors.
- It provides an investor with more chances to earn higher returns.
Disadvantages
- It requires a lot of time, patience, and dedication to analyze the markets.
- It is more costly and can generate a large tax bill.
- It provides active risks to investors and financial managers.
Active investing involves confidence and knowledge about the right time to buy or sell. In fact, this type of investing requires investors to be right more often than be wrong.
Passive Investing
Passive investors invest for the long haul. They limit the amount of buying and selling within their portfolios because they believe it is a cost-effective way to invest.
This strategy requires a buy-and-hold mentality—meaning, resisting the temptation to react or anticipate the stock market’s every move.
As a result, many passive investors buy an index fund because it helps them avoid analyzing individual stocks and trading in and out of the market. Their goal?
To get the index’s return rather than try to outpace the index!
[Index Fund: A type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. We’ll discuss more of this in a separate article.]
Like active investing, passive investing also has its advantages and disadvantages:
Advantages
- It is less expensive and time-consuming.
- It offers lower fees, costs, or capital gains taxes.
- It lets a company’s success drive your returns.
Disadvantages
- It is limited to a specific index or pre-determined set of investments with little to no variance.
- It only provides an “average” return.
- It makes investors and financial managers slow to react to risks.
Unlike active investors who value being right more often, passive investors keep their eye on the prize and ignore short-term setbacks.
Now that we know the differences, advantages, and disadvantages of these two types of investing, the question we need to answer next is:
“Which investing strategy is the right one for me?”
According to Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist of Altimetry Financial Research, the trading strategy that will work for you ultimately depends on your lifestyle.
It depends on how much time you want to devote to investing, and whether or not you want the best odds of success over time.
Professor Litman says nearly all wealthy families own stocks through passive investment funds. Instead of spending their nights and weekends researching stocks and bonds, they enjoy their time or put more time into doing the work they know so well.
In other words, these families don’t try to beat the market; they simply ensure the overall returns of the market.
When to Consider Active Investing
With more investors choosing passive investing, you might be wondering:
“Is there a time for me to become an active investor?”
As Professor Litman said, the core of your investment portfolio should first be invested in the best passive funds that fit your lifestyle or the necessary asset allocation from your personal timetable.
Then, let’s say after building your core portfolio through passive investing, you’d like to try to beat the market through active investing. Is it okay for you to do that?
YES!
You’re free to do that without having to worry. Why?
It’s because your core portfolio is already built and even if you encounter some setbacks in active investing, you won’t jeopardize your and your family’s financial future!
Additionally, you’ll have passive funds in your portfolio to benchmark against your own stock-picking performance.
Oh, and one more thing!
Professor Litman says it doesn’t make sense to be an active investor in passive funds. Once you have a good, well-diversified fund for your asset class, you have to stick to it.
There are times when many investors jump from fund to fund in an attempt to generate better performance. This makes them chase after underperforming funds and leave the ones that are about to outperform others.
In fact, a study by Money magazine found that the average fund gained about 500% over the 14-year period from 1984 to 1998. Unfortunately, most fund investors during that time only received less than half of that amount.
The reason for that?
Those investors tried to become active investors with passive funds! According to Professor Litman, traders who are like this buy one fund one day, a different one the next day, sell, then go back again into one fund or another—the cycle repeats and nothing significant happens.
In his words:
“Jumping in and out of funds does not make sense. It’s just another form of uneducated, low-resourced active investing.”
We hope you learned a lot from the continuation of our discussion on the fourth discipline of the giants of investing!
Remember: Choosing to be an active investor or a passive investor depends on your lifestyle and asset allocation.
If you have a strong desire to test your own active investing, first make sure that you have a solid portfolio built through passive investing and a strong foundation of disciplined investing.
As Professor Litman said, whether you’re an individual investor or a family investor, asset allocation should be first and foremost—using the right passive funds.
Take note of this investing discipline and the tips associated with it!
(This article is from The Business Builder Daily, a newsletter by The I Institute in collaboration with MBO Partners.)
About The Dynamic Marketing Communiqué’s
“Wednesdays: The Independent Investor”
To best understand a firm, it makes sense to know its underlying earning power.
In two of the greatest books ever written on investing, the “Intelligent Investor” by Benjamin Graham and “Security Analysis” by David Dodd and Benjamin Graham (yes, Graham authored both of these books), the term “earning power” is mentioned hundreds of times.
LITERALLY.
Despite that, it’s surprising how earning power is mentioned seldomly in literature on business strategy. If the goal of a business is wealth creation, then the performance metrics must include the earning power concept.
Every Wednesday, we’ll publish investing tips and insights in accordance with the practices of some of the world’s greatest investors.
We make certain that these articles help you identify and separate the best companies from the worst, and develop your investing prowess in the long run.
Our goal?
To help you get on that path towards the greatest value creation in investing.
Hope you’ve found this week’s insights interesting and helpful.
Stay tuned for next Wednesday’s “The Independent Investor!”
Cheers,
Kyle Yu
Head of Marketing
Valens Dynamic Marketing Capabilities
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