Should You Be A Passive Or Active Investor?

After all is said and done, and you are now getting close to the end of the course, it might be relevant to ask yourself the following question:

Should you invest passively or actively? Or should you do both?

The fact is that the majority of retail investors perform significantly worse than the stock indices. The reason for that should be clear after coming this far in the course:

1. Overtrading – too much buying and selling. Too much switching.
2. Behavioral mistakes. Sell in the midst of panic and reentering on the way up.
3. The results of 1 and 2 mean most likely most investors have no clear-cut plan.

One of the most important factors in investing is to know both yourself and your financial goals. One of the earlier lessons was that women on average perform better than men. This is because they are not trying to be smart. Many of them invest passively.

Active vs passive investing

Active investment is a form of investment strategy that involves actively buying and selling assets in the hope of making profits and outperforming a benchmark or index.

An example is a trader or a hedge fund. They have a benchmark and they try to outperform that benchmark. Most mutual funds are still actively managed.

Sadly, most active funds don’t manage to beat the benchmark, also because many have management fees of 1% or more. The truth is, on aggregate, most funds can’t beat the benchmark because it’s a zero-sum game in relation to the benchmark.

Opposite, a passive fund only tries to track the movement of a benchmark. The managers are not trying to outperform the benchmark. You will manage the return of the index minus a small management fee.

You as an investor can either choose to manage your capital by actively picking stocks, or you can invest via mutual funds (passively or actively).

Pros and cons of active investing:

Let’s first look at the pros of active investing:

• An active fund has the flexibility to adjust position sizes and deviate from the benchmarks. The reward could be better return than the benchmark. Warren Buffett is a perfect example of an investor that has managed to beat the markets over long periods of time.
• The investment mandate is often wide, both in terms of markets and market directions.

The cons of active investing:

• Active investing means higher management fees – often above 1% annually.
• Increased risk. Most active funds don’t beat their benchmark.

Pros and cons of passive investing:

Warren Buffett recommends passive investing if you don’t know have much knowledge or capacity to invest.

The pros of passive investing are these:

• Lower cost. The annual management fee can be as low as 0.1% while most have less than 0.5%. Over a couple of decades, a reduction of 0.5% in fees amounts to a lot of money.
• We would argue you lower the risk of failure. You only have systematic risk, ie. market risk, and no risk for misinvestments.
• You know what you get. You get the market returns minus the management fee give or take a small amount from the benchmark.

The cons of passive investing:

• If there is a bear market, you’ll stand no chance of getting any better returns (you could as an active investor).
• It’s boring. However, this might as well be an advantage.

Should you pick an active or passive fund or investing style?

It all depends on your investment goals and your investment knowledge. Our opinion is that most investors are better off focusing on their jobs and instead of saving regularly into mutual funds, perhaps both passive and active funds for diversification.

If you choose an active investment style, keep in the back of your mind that most investors fail to beat the averages, or your active funds will most likely not beat the benchmark over a decade. This is the (sad) math of investing.

Given that passive investing offers higher returns with lower costs, a passive approach might be most suitable for you.