Smartmoney Rules™ on Active and Passive Investing… and Why It Matters to You!
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SMARTMONEY RULES™ ON ACTIVE AND PASSIVE INVESTING… AND WHY IT MATTERS TO YOU! BY STEVE JUETTEN, CFP® AND DAN MAUL APRIL 2016 Helping you take care of your money so you can do more of what you love! SmartMoney Rules™ on Active and Passive Investing … and why it matters to you! By Steve Juetten, CFP® and Dan Maul March 2016 Introduction You may have heard the terms "active" and "passive" investing. In this special report, we are going to shed some light on these two terms and explain why it matters to you. First, we want to make a distinction between investing and saving. Investing is long-term oriented and the objective is to make your principal grow as much as possible. Saving is short-term oriented and the objective is to protect your principal and make it grow a little. Unfortunately, there is no such thing as a free lunch. If an investor wants his or her principal to grow significantly, she or he must accept more risk as defined by the potential loss of the principal. Savers are willing to have less growth in order to have more protection of the principal. Before we get into the differences between active and passive investing, here is a brief background on investing. Investing Basics Most investors assemble a mixture of stocks, bonds, and cash with their goal being to see their investments grow. While some people buy individual shares of stocks, most investors use mutual funds to create a mix of securities. A mutual fund takes in money from many smaller investors and then buys stocks, bonds or other securities with the money that investors have contributed. Assembling a mix of securities (or mutual funds that hold securities) is called a portfolio and many academic studies show that the primary driver of an investment portfolio's return is its asset allocation. Asset allocation refers to how the investor splits or allocates her or his money between major classes of investments: stocks, bonds, and cash. Academic studies have shown that asset allocation is the most important factor in the return of a portfolio. Still, most investors waste their time trying to decide between the individual securities that are within asset classes. What is active and passive investing? Active investing refers to the approach an investor (or mutual fund manager on behalf of the fund’s investors) takes when he or she is picking individual stocks, mutual funds, or other securities that they believe have the greatest potential to appreciate. When a security the investor has chosen does not meet expectations, it is sold and another one is purchased in its place. This is what we mean by active investing. Passive investing is the approach an investor uses who is simply trying to match the returns of an asset class as a whole. A passive investor will choose an entire asset class (or a subset of an asset class) instead of trying to pick an individual stock or mutual fund. Sometimes you will hear passive investing referred to as "index" investing. However this is not quite accurate; index investing is the most common approach to passive investing, but there are others. Index investing is used when an investor chooses a mutual fund that matches the securities held by an index. The most popular index is the Dow Jones Industrial Index, made up of the 30 largest companies in the United States. There are many other indexes, for example, the S&P 500 Index (largest 500 companies in the U.S.), Russell 2000 (U.S. companies ranked #501 to 2,500 by size) and many others representing virtually every security market in the world. Most investors don’t choose individual stocks or bonds. They use a mutual fund to choose securities for them. Mutual funds follow one of two approaches when they choose a security: either active or passive so when an investor chooses to invest in mutual fund “A” or “B”, the investor is choosing an active or passive approach. Approximately 75% of individual investors use an active approach to investing. Among major institutional investors, for example corporate and public pension plans, approximately 66% use active investing. In summary, think of active versus passive investing this way: suppose you're sitting on a hill, looking out over a forest made up of different kinds of trees and you want the forest to grow. Active investors will try to pick which individual tree will grow fastest. Passive investors will choose the whole forest. Which approach is better? Independent, unbiased academic research shows that passive investing provides better returns than active investing over longer time periods. Standard and Poors Company keeps track of the results that active and passive mutual funds achieve. Since 2002, they have published the SPIVA (S&P Index Versus Active) Scorecard. Here is what they found: Compared to an active approach to investing, indexing almost always works better over a five-year horizon. Over shorter time periods like one or three years, one approach may be better than the other, but over five years or more, a passive approach is better. Look at this graph showing how various investment sectors fared against their indexes. 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One of the arguments that active mutual fund proponents use is that actively managed mutual fund managers have the opportunity to move in and out of positions as market conditions dictate. The argument goes that this should provide a significant advantage for actively managed mutual funds. Unfortunately, this is not the case. In the two bear markets we have seen over the last decade, most active managers failed to beat their benchmarks. For example, less than 5% of actively managed small cap growth mutual funds and less than 10% of large cap growth mutual funds were able to beat their benchmark in 2008. Source: U.S. SPIVA Scorecards; more information can be found at www.standardandpoors.com/indices/spiva/en/us. Reasons Investors Still Use Active Investing If passive investing is superior to active investing, why do people still invest actively? There are probably many reasons, but here are some we’ve observed: Many people don’t know passive investing exists. Unless an investor has an MBA, he or she probably has never heard of the efficient market theory or capital market pricing (two key concepts in passive investing). If an investor has heard of passive investing, and asked her or his broker or financial advisor about it, the response probably went something like this: "Indexing is a good strategy, but it gives you average returns. Since we at the XYZ firm can give you above average returns, why would you settle for average returns?" In other words the people that could educate the average investor about passive investing, are the ones whose interests are not aligned with the investor and in fact, whose interests are opposite of the average investor when it comes to indexing. Brokers, fund managers and Wall Street professionals need to convince their clients and the investing public that only a skilled professional has the ability to achieve superior returns. If it were widely known that passive investing was a viable alternative, they would all lose their jobs. Belief in the Performance Fairy. Frank Armstrong III in his book "The Informed Investor" coined the phrase "the performance fairy." Mr. Armstrong notes, “if you believe in performance fairies, you are convinced that somewhere out there is one that can beat the market. You might even believe that you yourself are a performance fairy. You persist in this delusion against all the available evidence, but remember, it is extraordinarily difficult to beat Mother Market. Few actually do it over the long haul, but many a fool continues to confuse pure, dumb luck with skill." This is a clever and cute way to point out that all around us, especially in Western society, we celebrate the winners and feel sympathy for losers.