Active Versus Passive Investing

Active investing is a strategy that investors use when trying to beat a market or appropriate benchmark. Active investors rely on speculation about short-term future market movements and ignore vast amounts of historical data. They commonly engage in picking stocks, times, managers, or investment styles. As later steps demonstrate, active investors who claim to outperform a market are in essence claiming to divine the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use are best described as qualitative or speculative, largely including predictions of future movements of the stock market based on too little information. Bottom line, these methods prove self-defeating for active investors and actually lead them to underperform the very markets they seek to beat.

The first step in any 12-Step Program focuses on recognizing and admitting a problem exists. In this case, this means identifying the behaviors that define an active investor.

These include:

  • Owning actively managed mutual funds
  • Picking individual stocks
  • Picking times to be in and out of the market
  • Picking a fund manager based on recent performance
  • Picking the next hot investment style
  • Disregarding high taxes, fees and commissions
  • Investing without considering risk
  • Investing without a clear understanding of the value of long-term historical data

There are sharp contrasts between the behaviors of passive investors and active investors. Passive investors don’t try to pick stocks, times, managers, or styles. Instead, they buy and hold globally diversified portfolios of passively managed funds. The term “passive” translates into less trading of the fund’s portfolio, more favorable tax consequences, and lower fees and expenses than actively managed funds.

A passively managed fund or index fund can be defined as a mutual or exchange traded fund with specific rules of ownership that are adhered to regardless of market conditions. An index fund’s rules of construction clearly identify the type of companies suitable for its investment. Equity index funds would include groups of stocks with similar characteristics such as size, value and geographic location of company. This group of stocks may include companies from the United States, foreign countries or emerging markets. Additional indexes within these markets may include segments such as small value, large value, small growth, large growth, real estate, and fixed-income. Companies are purchased and held within the index fund when they meet the specific index parameters and are sold when they move outside of those parameters.

Figure 1-1 illustrates the differences between active and passive investing. Introduced in the early 1970’s, index funds now account for about 25% of all individual investment assets and about 40% of all institutional investments, by my estimates. Index funds investing has caught on, and for good reason. As the chart shows, index investors fair far better in returns, incur lower taxes and turnover, and enjoy a relaxed state of mind.

Figure 1-1