What do active investors do?
Active investors believe that markets are “inefficient”. They believe that at any point in time, there are always some securities that are mis-priced, enabling them to buy or sell making a profit. Professional active investors devote unbelievable amounts of time and resource towards trying to find that extra edge. They will then trade in and out of those securities to try and generate profits above the benchmark. They pour over company financials, visit with competitors, study all the latest economic releases, and try to predict everything from corporate earnings to the direction of interest rates and currency movements.
What do passive investors do?
Passive investors believe that markets are “efficient”. They believe that over the long run, the price of stocks and bonds reflect the true underlying value of those securities. As such, they do not seek to beat the market, but rather to “be” the market. They do this by using index funds and ETF’s (exchange traded funds) that mimic various components of the market. For example, rather than try to find that “next Apple or Google”, you can purchase (nearly) all large US stocks or (nearly) all small emerging market stocks in one go by buying the index in it’s cheapest form. Then, using the right asset allocation, they can create portfolio that has an appropriate risk exposure for the client.
Which style of investing performs better?
Passive investors outperform active investors more often than not. In the past 5 years, 75% of US Large Cap funds, 90% of US Mid Cap funds and 83% of Small Cap funds failed to beat their comparable indices. One reason for this may be the fact that market surges (up or down) are unpredictable missing just the top 25 days of market performance over the last 40 years would result in you having 3.6% less per year than if you had just stayed the course.
Which style should you use?
Investing in both active and passive investments makes sense. In smaller more specialist areas of investment it can sometimes be difficult to find the right passive investment. In larger markets ETF’s and indexes can be cheaper and more efficient. There are a variety of measures to make the right decision. Consult with a professional to show you the options. If they aren’t clear then be passive with them.