One of the first questions that comes up in investing is the concept of choosing active or passive investment strategies. What is the difference? Well, it is actually just as the adjectives sound. Active investing is choosing individual stocks/bonds or picking a money manager that will choose those financial instruments for you. The objective in active investing is to carefully analyze different companies and pick securities that will produce investment returns higher than index averages. For example, a money manager may pick Google (GOOG) stock to invest in because he/she believes that GOOG will outperform the S&P 500. What is the S&P 500 index? Well, the basic explanation is that it is an average of the largest 500 domestic stocks traded in the United States. Now the composition of the index and calculation of the index return is a bit more complicated, but it is all right to keep it simple for now. Now a money manager (usually a mutual fund portfolio manager) will pick 50-100 different stocks or bonds for you, so you do not have to. Each money manager has his or her proprietary method for determining which securities to purchase such that your investment will appreciate more than the average of all stocks or bonds traded in the financial markets. Passive investing is really the polar opposite. Passive investing just means that a money management firm believes that they are not smart enough to pick the best stocks or bonds. They simply invest in all the securities in a particular index. For example, if you invest in an ETF or index mutual fund tied to the S&P 500, the money manager invests in all 500 stocks. Your return will always be lower than the average investment return for the S&P 500. Why lower? Well, you have to pay a fee (referred to as an expense ratio) to the money manager for their work in trading the stocks, creating brokerage statements, and other things. These fees tend to be quite low; usually 0.2% or lower on an annual basis. Thus, if the S&P 500 goes up 10.0% during the year, your return will be 9.8% (10.0%-0.2%). An active manager will usually charge 0.8% on average. It can be more or less. You are paying extra because the active management firm has a team of security analysts that select stocks or bonds that will hopefully outperform the index averages. Why would you choose passive investing and just simply be average?
The choice of passive investing as a strategy comes from the difficulty that active managers have beating index averages over time. Active money managers have teams of incredibly smart analysts, but they can still make mistakes and trail index averages. When you use a passive investment strategy, you will only underperform the index average by your expense ratio. You are not picking securities that may go down more than the average market participant thinks. An example would be Apple (AAPL). Most money managers thought AAPL was a great stock purchase and piled into the shares over the last five years or so. Unfortunately, AAPL stock peaked at $705 per share in September 2012 and now trades around $420 per share today. Many financial pundits would tell you that they knew AAPL was going to go down. The funny thing is, that in official reporting to the Securities and Exchange Commission (SEC), AAPL was the most owned stock by Wall Street firms. So it is possible to lose money on a “sure thing”. Remember the economic saying that “there is no such thing as a free lunch”.
If you have an intelligent Financial Advisor, it must be relatively easy for that expert to pick the active managers that will outperform the market. Well, not so fast. In practice it is very difficult for active managers to beat index averages. Over the past 30 years or so, active money managers investing in stocks will beat the S&P 500 index slightly less than 50% of the time. Now I will explain that the S&P 500 is normally not the proper index to choose when measuring how an active manager performs for you during the year. I will cover that in another blog. Well, you can think of that as an exercise in tossing a coin. If you toss a coin once, there is a 50% chance it will be heads and 50% it will be tails. If you toss the coin another time, there is a 25% chance that you will toss heads two times in a row (50% chance heads in toss one times 50% chance heads in toss two). When you are investing, most money managers will tell you to look at things over the long-term. You should not just buy and sell every time you think things are uncertain. Uncertainty is a fact of life and also when it comes to financial markets and economics. So if active managers outperform index average 50% of the time, how many will outperform the market in five straight years? Well, it is just simple math from our coin exercise. To stop the suspense the number is 3.1%. The mathematical formula which you can do on your calculator or in Microsoft Excel is 0.5 raised to the 5th power (0.5 * 0.5 * 0.5 * 0.5 * 0.5). Now what if we extend the exercise to include ten years, the percent will drop to 0.1% (0.5 raised to the 10th power). When you convert the decision into mathematical terms, you can see that a Financial Advisor needs to be able to pick out the 3 out of 100 active money managers that will outperform the index. When you look at a ten year period, that Financial Advisor needs to pick the 1 money manager that will outperform the index out of 1,000 other choices. Wow! That is a difficult task.
Now I will admit that if an active money manager outperforms his/her index by a significant magnitude in any one year, he/she can underperform the index in the next year but still have an average investment return greater than the index for that two year period. With that being said though, your Financial Advisor has a very difficult job. If you are dealing with a ten-year timeframe, there are approximately 10,000 actively managed mutual funds. When you go to your local bank or full-service brokerage firm, you are asking your Financial Advisor to pick one of the 1,000 mutual funds that will outperform the market averages over a ten-year timeframe (Note there are only 10 in the entire universe of actively managed funds which fit the criteria which is 10,000 * 0.1%). Regardless of where you went business school or how long have been investing in the financial markets, that is an extremely tough order. Therefore, any Financial Advisor that infers that he/she can assist you in beating the market over the long-term is making a pretty lofty claim. Now Financial Advisors cannot guarantee returns; however, most financial professionals present information as if they will assist you in doing better than the financial markets on average. After going through that mathematical exercise, you can see how unlikely and/or challenging that really is. How does the shell game turn then? Most financial professionals will focus on matching your risk tolerance to your financial goals when recommending how to allocate your portfolio into various investments and let you know what investment return you need to achieve your goals but also sleep at night. What you will not be shown is how your investment portfolio would do if you simply followed that financial professional’s advice but chose only ETFs or index mutual funds (i.e. a passive investment strategy).
When you are dealing with a financial professional, you need to ask him/her what they think about the active versus passive investment debate. Now I am not saying that one is better than the other. My goal here is that your financial professional should be able to show you how his/her investment ideas are performing better than you just investing in every security in the index. If they cannot or are not willing to do that, you should walk out the door (or run if you are able to). I will cover how you can keep track of your investment performance if you choose an active investment strategy in the next blog.