Tuesday, April 15, 2014

Active vs. Passive Investing

When you invest, do you prefer to check on your portfolio and make buy/sell decisions on a regular basis?  That's Active Investing.  Or do you prefer to buy and hold a few index funds?  That's Passive Investing.

The average Active Investor does not beat the average Passive Investor.

It may be difficult to prove this exhaustively but consider the S&P 500 index which contains the vast majority of the market cap of all publicly traded US stocks.  If the S&P500 returned X% last year, it is likely the average stock investor returned something around X% last year as well.  In fact, because roughly 80-90% of the participants in the financial markets are institutions, it is likely that the average mutual and hedge fund also returned around X% last year as well.

Active investing involves more frequent trading than passive investing (which is essentially buy-and-hold.)  When the average active investor receives the same return as the average passive investor BEFORE he/she pays trading commissions, the average active investor ends up making LESS than the average passive investor AFTER fees!

You can be an average investor with very little work!

Funny thing about investing, as opposed to many other disciplines, is that you can be nearly average with very little experience.  The same cannot be said of medicine, sports, law, engineering, pretty much every respectable profession.  Simply buy an S&P500 index fund like the SPDR S&P500 Fund, SPY, or a total stock market index fund like Vanguard's VTI and you're on your way to being an "average" investor.  You don't need to know a thing about investing or finance, just a few thousand dollars to open a brokerage account and you can be average!

But wait, before you make the leap.

Being average means you accept the average returns of the market (which are around 7-10% per year over the LONG term) but you also accept the average losses and risks.  In 2008, the S&P500 lost 38% which means the average investor lost a similar percentage of his investments.  How much risk you want to accept depends on a thorough analysis of your present and projected (future) financial situation.  You will also likely need to consider an asset allocation that includes not just stock but also bonds and maybe commodities and real estate.

Investing isn't as simple as blindly buying a few popular index funds but it isn't as complex as picking the right stocks and trading in and out of the market every few days or weeks.  In future posts, I'll go over the principles in investing sensibly.

No comments:

Post a Comment