Active investing sounds like a positive, proactive way to invest your assets. Passive investing sounds boring – your financial advisor is not doing much. Here are 5 key differences between active and passive investing.
1. It’s a Religion
It is what you and your financial advisor believe.
At the Church of Active Investing advisors sell performance to gain control of your assets. They want you to select them based on undocumented sales claims that they can produce superior returns.
At the Church of Passive Investing advisors do not sell superior performance. They vehemently believe advisors can get lucky during short time periods, but they cannot produce exceptional returns over longer time periods. So why try? Investors are better off with passive investment strategies.
2. Asset Class Investing
You invest in securities, funds, or ETFs to exceed or match the performance of a particular asset class. For example, large capitalization, U.S. stock is an asset class that is represented by the S&P 500. Your goal is to capture the performance of this asset class.
The active manager says he can beat the performance of the S&P 500 with superior stock selection. The passive manager says invest in an S&P 500 index fund and capture the performance of the asset class for less risk and expense.
3. Beat the Market
Active management is a continuous series of investment decisions that are supposed to produce superior results. Examples of decisions include asset allocation, security or fund selection, when to buy, and when to sell.
Advisors who sell active management have to beat the market to justify higher exposure to risk and expense. For example, an actively managed mutual fund may charge 4-6 times higher fees than a passively managed index fund.
4. Match the Market
Passive management makes decisions for asset allocation and fund or ETF selection and does not change them. They become the static decisions of passive investing.
If you can’t beat the market your next best option is to match the performance of the market. For example, the S&P 500 represents the performance of the stock market. It is up 10% during the year and so is your investment. You have matched the performance of the market.
Computers run passive investing so it is 75% to 90% cheaper than active investing that requires continuous tweaking and management by expensive professionals.
5. Investment Risk
Advisors who sell active management have to beat the market to justify the extra expense and risk. If they beat the market you are rewarded for the extra risk. If they lag the market you are not rewarded for the risk.
Advisors who sell passive management do not take extra risk to beat the market. They take the same risk as the market they intend to duplicate.
Who is right?
There is no right. It depends on your financial advisor’s beliefs.
However, there is a bottom-line. You have a big problem if you are paying for active management and your advisor is lagging the performance of the market indices after all expenses are deducted.