Your Investments: Passive versus active investing
Creating your asset allocation – stocks, bonds, cash in your portfolio – is the most important task you can do as an investor.
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When it comes to investing, there are two approaches that one can choose to
implement: a passive investing approach or an active asset-management approach.
Let’s take a look at each method and try and figure out which is
Passive investing generally means that the amount of
buying and selling is limited, or virtually non-existent. The intention of each
investment is to be held for the long-term, and not try and cash in on
short-term profits. It is also known as indexing or a “buy and hold” strategy.
There are many advantages to this style. Limited transaction costs, more tax
efficiency and lower management fees are just some of the
Proponents will say that since most portfolio managers are
able to outperform the broader market, there is no point in trying. Instead,
they suggest you just buy either good-solid companies or track market indices
with index funds or Exchange Traded Funds (ETFs), claiming that that is the
surest and cheapest way to ultimately profit.
management, on the other hand, is defined as an attempt to “beat” the market as
measured by a particular benchmark or index. The S&P 500 Index is an example
of an index that gauges the performance of the large-cap US stock market – known
as “blue chip” stocks.
In an actively managed portfolio, the investment
manager uses a whole host of criteria to help make investment
Managers may incorporate market trends, economic data and
political events, as well as the individual situation of a specific company,
within his decision. The goal of active fund management is for the investor to
try and outperform the specific index to which he is comparing
Which works best?
Investors always want to know which method is
the best. It’s like trying to decide between Coca-Cola and Pepsi. Both
sides are able to make logical arguments to defend their favorite approach. The
proponents of passive investment generally believe that it is difficult to beat
the market. They therefore believe that if it’s so hard to outperform the
general market, it’s best to link yourself to the broader market indices and let
the market do the work for you.
Conversely, active managers believe the
market can be beaten.
By buying and selling, they believe that they can
take advantage of the irregularities in the market that can help produce
superior returns. Unfortunately for them, data seems to show that in most cases
they don’t succeed in producing superior returns, certainly not over the long
In what could be considered rather ironic, it is the low cost of the
passive approach that can end up hurting returns.
Research has shown that
investors tend to “over trade” low-cost ETFs. Robert Powell of Marketwatch.com
quotes David Zuckerman, chief investment officer at Zuckerman Capital
Management, as saying, “Research has shown that ETF investors tend to trade much
more frequently than investors in similar open-ended mutual funds, and studies
have shown that high portfolio turnover hurts returns.”
Big help there,
right? It’s just that there is no empirical answer. I actually like to use a
blend of both strategies, where the core or base portfolio is more of a low-cost
buy-and-hold approach, and overlay certain strategic investments to try and
generate more value.
The one thing that I need to stress is that for
investors with long-term investment horizons, it’s important to realize that
both strategies will have their good times and their bad
Individual investors should try to ignore the trend of the moment,
and stick with just one strategy.
I can’t begin to tell you how many
people I have met that jump from one strategy to the next. They are the ones who
end up losing. If you stick with a strategy, your chance of success is much
As I’ve mentioned in previous columns, creating your asset
allocation – the mix of stocks, bonds and cash in your portfolio – is the single
most important task you can perform as an investor. Many studies have shown that
the proportion in which you hold stocks, bonds and cash has a greater effect on
your portfolio’s returns and its volatility than the individual investments you
Aaron Katsman is a licensed financial professional both in the
United States and Israel, and helps people who open investment accounts in the
United States. Securities are offered through Portfolio Resources Group, Inc. a
registered broker dealer, Member FINRA, SIPC, MSRB, SIFMA. For more information
visit www.aaronkatsman.com, call (02)
624-0995 or email: firstname.lastname@example.org.