Client Q&A:
Active Versus Passive Investing

Active Versus Passive InvestingNext on the Wednesday Q&A list . . .

How to convince people that a passive methodology, besides providing fewer headaches, is a superior strategy to active, day trading mentality?

This is an interesting question, and while I have an opinion, I’m not sure I have THE answer.

In the world of investing, there are 2 major camps: active and passive.

Active investing generally attempts to achieve market-beating investment performance through the selection of the right investments at the right times while avoiding the wrong investments at the wrong times.

On the other hand, passive investing generally subscribes to the belief that any success in active management (as described above) is attributable to luck as much – or more – as it is based on skill. In other words, while an active manager or investment might beat the market for a period of time, it is difficult to determine if any market-beating performance was based on any demonstrated and repeatable skill or if they just happened to “guess” right.

Of course, active investment managers would never use a word like “guess” to describe what they do. Instead, they use complex, jargon-filled investment philosophies and processes to create an impression of skill-based, information-rich investment decision making.

Rather than bore you with the details of what active management is and the many shapes and forms it can take in your portfolio, I prefer to briefly explain why I believe passive investing is ALWAYS the better alternative.

First, as I’ve written about before, what if your active manger or advisor is wrong?

A big problem with stock picking and market timing (active management) is that it uncouples your results from that of the overall market.

In an attempt to beat the market, your active investments may do better that the market.

Or they may do worse.

The problem is, you never know when you’re going to get outperformance or underperformance relative to the broader investment markets. And given this fact, it makes any sort of meaningful financial planning impossible.

There is something called underperformance risk that comes with active investing. The good news is you can avoid it completely with passive investing.

Let’s say in an “average” year the stock market produces a return of 10%.

If you own a passive, total market portfolio, the equity portion of your portfolio will, in the “average” example year above, produce a return of 10% minus your costs.

But an active manager’s results to could fall anywhere. They appeal to your desire to beat the market with the hope they’ll do better than the 10% example above.

But what if their investment philosophy/process du jour is off a bit? Or worse, what if they’re completely wrong?

In an average year of 10%, an actively managed portfolio could deliver 10%, or 20% or negative 15%.

This is additional uncertainty that can be completely eliminated with a low cost, total market passive investment portfolio.

Besides, sound financial planning isn’t about “hope,” but that’s the foundation of active management.

Next, costs.

Actively managed investments are more expensive than their passive investing alternatives. Often, they’re much more expensive.

And in addition to raw costs and expenses, they create more tax liabilities in non-retirement accounts. Taxes are just another layer of costs that eat into your returns and ability to achieve your financial goals.

As I mentioned just last week, investment costs are one of the few things you can control with regard to your investment portfolio, and I believe it’s important that you exercise your control in this important area.

Also, active managers are news reporters. Since they can’t see the future (I can’t either, by the way), they spend an awful lot of time telling you what already happened. They do this in an effort to explain why your money performed the way it did.

In the investment consulting world this often referred to as “performance attribution.” All it amounts to is reporting yesterday’s news.

But in addition to explaining what already happened, they usually follow it up with what they, their firm, an economist, or some third-party research group thinks will happen in the future.

This usually results in liquidating the investments or funds that recently did poorly (selling low) and reinvesting in investments or funds that have recently done well (buying high).

This is the exact opposite of how successful investing works.

You’re paying above average fees for active management that doesn’t work well with your financial plan and most of these active advisors are chasing the “next hot thing” with your money.

And not surprisingly, they’re always chasing but never quite catching their elusive promise of beating the market.

In fact, most do worse than the overall market. For more details on this, read this report.

So back to the original question above:

How to convince people that a passive methodology, besides providing fewer headaches, is a superior strategy to active, day trading mentality?

As I mentioned earlier, I don’t think there is an answer to this.

I used to spend a lot of time trying to convince people that my investing worldview made more sense than active investment strategies.

I mean, c’mon, passive investing is based on academic, research-based evidence for crying out loud!

However, after doing this for over 20 years, I’ve learned that some people aren’t capable of letting go of the old Wall Street active management approach.

As you may suspect, advisors, brokers and others whose compensation is based on continuing to perpetrate this flawed approach to investing have a conflict-filled bias to maintain the status quo even if it’s not in your best interest.

And I’ve even met some potential clients over the years that don’t believe (or don’t want to believe) that there is a simpler, less costly way to invest that results in less uncertainty and more confidence in reaching their financial goals.

I’m always happy to explain how I do things and why I believe what I do about investing, but I’ve given up on trying to convince those folks who have no interest in anything other than finding the next great investment idea.

If you have questions about your investments or would like to discuss a low-cost, total market investment alternative to the typical active management advice, give me a call. I’d be happy to have that conversation with you

Note: While the term “passive” is the opposite of the term “active,” I don’t really like using “passive” to describe my investment approach. It isn’t passive, buy & hold, or set it and forget it. While we’re not trying to outsmart the market by picking stocks and time the market, there is a lot more to my investment implementation that what I’ve described above. Happy to explain more about it with you or I can address in a future email if there is interest. Let me know.

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Russ Thornton
Russ Thornton
Hi there! I'm Russ, and I help women in their 50s and 60s achieve and maintain their desired lifestyle leading up to and throughout their retirement years. Imagine being able to look forward to a comfortable and confident financial future...
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