The Ultimate Investing question… Passive or Active?

13 Jan

Over millennia, we have seen debates around the world about whether you should be an active investor, whereby you have a pretty active role in choosing the assets you buy and sell in your portfolio. Or whether to be a passive investor, whereby you follow the market or a trend you believe will be big in the future.

Over the course of the last few decades, we have seen a pivotal change in the overall consensus of investing, with more people moving into the passive camp.

Today, I want to highlight the advantages and disadvantages of both and to educate you on why I have decided that I shall be an active investor for my own portfolio.

Once you have read through it all, it is up to you to make up your own mind about what style of investor you are going to be.

Passive Investing: “Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing in one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.” - [1]

Advantages:

Diversification, being able spread risk broadly, such as when you invest in the broader market, such as an S&P 500 index.
Lower fees
Tax efficiency
Less time needed for research, simplicity: You do not need to research into every stock or financial product.
Can dollar cost average, instead of timing the market: You can decide to invest a small sum of money every month, three months etc. Rather than trying to time the market, you consistently invest for a set period of time.

Disadvantages:

Subject to total market risk: Whereby if the broader economy is not doing so good, the markets will correct/crash.
You will not see returns higher than the market: As most passive funds, ETF’s etc. They only track the overall market performance.

Seems like a pretty good idea, rather than doing all the work to research the market, just follow the overall market trajectory and returns. You spend less on fees and it is much more tax efficient to put all your money into one index. In fact, for 80-90% of you who are reading this blog right now, it is probably the most effective way to start and continue investing for the long term.

However, with the current market climate and with interest rates on the expected rise, I suspect that active investing will get bigger again over the next few years…

Let’s see why!

Active Investing: “Active investing refers to an investment strategy that involves ongoing buying and selling activity by the investor. Active investors purchase investments and continuously monitor their activity to exploit profitable conditions.” [2]

Advantages:

Flexibility: Active managers aren't required to follow a specific index. They can buy those "diamond in the rough" stocks they believe they've found.

Hedging: Active managers can also hedge their bets using various techniques such as short sales or put options, and they're able to exit specific stocks or sectors when the risks become too big. Passive managers are stuck with the stocks that the index they track holds, regardless of how they are doing.
Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.
Risk management: Active investors and fund managers can select stocks based on the prevailing market conditions.
Short-term opportunities: Active investors can make use of short term (3 months or less) opportunities, which in turn gives them a range of tools to choose from when investing.
Have more opportunities to invest in different asset classes: Active investors and funds are more likely to be able to delve into different asset classes, therefore diversifying risk away again.
Can meet specific needs of ethical and moral criteria: With most passive funds, a lot of them do not meet a lot of investors criteria, such as not to invest in mining, or child slavery. When you invest in the top 500 companies in the U.S for example, you have no idea what these companies are doing with your money.

Disadvantages:

Very expensive: The average expense ratio is 1.4 percent for an actively managed equity fund, compared to only 0.6 percent for the average passive equity fund. Fees are higher because all that active buying and selling triggers transaction costs.. All those fees over decades of investing can kill returns.
Active risk: Active managers are free to buy any investment they think would bring high returns, which is great when the analysts are right but terrible when they're wrong.
Poor track record: The data show that very few actively managed portfolios beat their passive benchmarks, especially after taxes and fees are accounted for. Indeed, over medium to long time frames, only a small handful of actively managed mutual funds surpass their benchmark index.
Minimum Investment amounts: Some Actively managed funds in fact need a minimum to invest in that fund, such as $10,000. Or some brokerage platforms need a minimum of $100 per trade etc.

As you can see, the age old question of Active versus passive comes down to a few things, whether you have the time to do the research, whether you are ok taking on more risk for more specific investments, and also whether you can take on some more complexity regarding tax etc.

At the end of it all, it mostly comes down to whether you also believe the wider market will do well over the long term or whether you have the confidence and knowledge to beat the markets over the long term.

Majority of the time, you won’t beat the market, so it is truly up to you to decide whether you are a passive or active investor.

I have decided that I want to follow along the path of active investing, to test my own knowledge and because I believe that the overall markets will not increase significantly over the next ten years. I do not see a lot of growth to be had, however I may be entirely wrong and therefore you need to make your own decision on what you should do as an investor.

Let me know in the comments below what path you will choose,

Until next time,

Take Back Control

If you have found this Blog valuable, I would love it if you shared it with friends and family. The more the merrier, as I want to see each and every one of you learn to Take Back Control of your Life-Health-Wealth !

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References List:

[1] - https://www.investopedia.com/terms/p/passiveinvesting.asp

[2] - https://www.investopedia.com/terms/a/activeinvesting.asp