Active Investing vs Passive Investing

Usually there is not a clear cut winner since most of the time the answer is “it depends,” but in this case, passive management is the way to go!

Active Management

Active management (active investing) is having a professional investor, generally for a percentage fee, who’s full time job is to watch, study, and pick opportunities from the market and make you money. That sounds great, right? Someone who spends their working life to manage a collection of stocks should do very well. It’s counterintuitive, apparently having this expert does not pay out for you the investor.

Passive Management

Passive management (passive investing) is instead of hand-picking stocks, you buy a little bit of all stocks by buying an index fund.  The thought process is that you don’t know which stocks are going up or down, but in general, as it’s been historically seen, stocks as a whole, go up. Technically you you don’t have to buy all stocks with passive investing, but you buy a fund that buys a collection of stocks such as the very popular S&P 500 index, which is a collection of 500 large American companies.

Here’s a chart on why you should do passive management:
 Passive Management  Active Management
 Performance S&P 500 Index has returned about 10% a year Over a 10 year period, 80% of large-cap actively managed funds failed to beat the S&P 500 which is their benchmark
Management Fees A low cost index fund can cost as little as 0.04% (Vanguard VOO)  Let’s just say they are way more generally between 1-2%
 Warren Buffet The world’s best investor advocates passive investing  Mr. Buffett writes, “The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
 Health Reasons  It’s not up to the right manager, it’s just follow the index and rebalance your assets every once in a while.  Constantly checking stocks, FOMO, lose sleep, shortens life (probably)

A Little More Depth Into Everything

Performance

By now, if you haven’t heard passive investing is the clear winner, then let this article inform you of that. In a given year, it’s hard to tell if investors that beat the market, are good investors, or just lucky that year. You have to look at the market over a longer period of time to see a clearer picture.

There have been a few long term (10 years) studies stating that up to 71% of mutual funds underperform the S&P 500, net of fees. That means after you pay the fees, for these active managements, you’re worse off then if you just went passive.  Read this paper from UC Berkeley on Comparing Active and Passive Fund Management in Emerging Markets if you want to really go deep.

Expense Fees

Since Actively managed funds are generally run by people, it costs more.  Often times as much as 1 – 2% of the money you put in.  That means that whether the funds do well or not, the managers get their very generous salaries with some ridiculous bonuses. Have you seen Wolf of Wall Street? I love this movie, but I digress. Theses investors, always make their money so long as people keep investing with them. I don’t like to believe that every active investor is out to get their clients, but if they don’t know that they can’t beat passive management in terms of gains, then they are either stupid or delusional. Either way, stay away!

Passive Management follow an index which is a collection of stocks. Since there are so many people watching stock prices, computers analyzing stock prices every second, and prices are reflective of all information publicly known, we are in a “highly efficient” market. The passive investor believes that in a highly efficient market, it’s very difficult to tell which individual stocks will go up or down, but believes the economy will continue to grow which is what the index is tracking.

Warren Buffett Approved

Warren Buffett, the Oracle of Omaha, the best stock picker, and famous investor has advised his wife to buy index funds after he’s departed.  I think he believes he can beat the market which he has, but he realizes most cannot and do not take this risk.

The Million Dollar Bet
Started in 2008, right before the housing crash, Warren Buffett bet $1M against Protege Partners that an index fund of his choice would outperform their actively managed funds over a span of a decade. By the end of the first year, due to the housing crash, Buffet’s had lost 37% and was trailing Protege’s loss of only 24%.

By year 5, despite a terrible start, Buffet and Protege made it out of the red and Buffett finally took the lead. By the 10th year, Buffett’s returns were at about 7% and Protege had only done about 2.2% which led Protege to concede before the true deadline.

How Do I Invest Passively?

So now that we know passive management is the way to go, what does that mean?  Well you can do what Buffett did and just buy a low fee vanguard S&P 500 fund such as VFINX.  A law of investing is the more risk you take, the higher the returns on average. We know that the S&P 500 returns about 10% a year on average, but in a given year like 2008, it could do -37%. If you want to lower the risk and return we can do some asset allocation which is my next post.

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