Active versus passive investing

  Are you an active investor? You think you can invest better than the markets? Over time everyone knows that active mutual funds on average underperform index funds. wait! you invest passively? only a dummy brain would think that the markets are fully efficient. maybe that's taking it too far. Chances are if you don't get the joke I'm making here, you haven't seen investors Duke it out in the active versus passive debate because my god it can get heated.

 While most investors agree that investing is fundamental to personal finance. They can't seem to agree on the best approach. On the one end you have being come into active investors, believe that passive investors to be lazy blind to the irregularities at the market and on the other passive investors decry the high fees and arrogance of the active crowd. But while it's easy to make fun of the argument, it is important to understand the differences in the two strategies so that you can decide your own approach when it comes time to invest.

 So let's go over the active versus passive debate and whether these two sides can be reconciled. before we get into this debate I want to highlight that the point of this post is not to disprove either school of investing. As someone who's actually invested both passively and actively in the past, I believe there are merits to both approaches. And while some people will passionately argue, that there's only one right way to invest I don't subscribe to that belief. That being said it is important for anyone starting off to understand the active versus passive debate and well I have my own biases. My hope is to present the argument in a neutral setting so that you can appreciate both sides.

 So let's start at the very beginning. what does it actually mean to invest actively or passively? Well the actual definitions of the two vary depending on who you ask. But here are the main characteristics of each approach. 

An active investing strategy is any approach that involves monitoring the prices of your positions to find buying and selling opportunities. Positions are selected based on research or analysis and the goal of the portfolio is often to outperform some sort of benchmark. A benchmark can be an index or a mix of indices, that offer some gauge of how the overall stock market or segment of the market has performed. the amount  investor outperforms their benchmark is referred to as alpha return. So active investors are looking to achieve alpha when they invest. There are an almost endless number of active strategies, some of which actually offer conflicting views about individual positions. but that's the broadest definition of the philosophy.

 

Passive strategies on the other hand don't focus on short-term fluctuations in a stock's price. Investors instead buy positions as soon as they have the money to do so or when they decide they want to own the position. Passive investing also involves little to no research or analysis of individual companies. instead, investors focus on spreading their money across a large number of stocks or diversifying to gain exposure to the stock market as a whole. In this way passive investing doesn't look to beat the benchmark but instead to mimic it. There are different approaches to passive investing, but index investing is one of the most popular applications and has sort of become synonymous with the school of thought itself. 

Index investing simply involves buying index funds that directly copy an index, since indices are viewed as proxies for the stock market or its segments. As a whole invest an index offers exposure to the broad performance of stocks. So those are the two approaches to investing. one focuses on analysis and valuations at trying to achieve alpha and the other on diversification and long-term exposure. But why don't passive investors also try to earn alpha?

 Well the reason has to do with how passive investors view the market and the competence of individual investors. Passive investors largely subscribe to the efficient market hypothesis. EMH is a theory that was developed by Eugene fama in the 1960s, that states that at any given time a stock's price will reflect all available information and trade at its fair value. All this means is that investors cannot identify stocks that are too expensive or too cheap everything will trade at its intrinsic value. After all with so many traders participating in the market, researching companies and looking for new information, the resulting buys and sells on aggregate should bring the SoCs price close to its actual worth.

 Active investors on the other hand don't believe that markets are completely efficient. Instead they believe a stock's price can often deviate from what it's actually worth. In that by carrying out research and analysis one can identify these opportunities. One of the tenants of this belief is investor irrationality. Whereas the efficient market hypothesis assumes all investors are rational. Active investors believe that market participants frequently exhibit irrational behavior, with behavioral biases sometimes overshadowing logic. When an investor makes decisions, other more mechanical factors can also affect the efficiency of the market. Such as investment mandates that limit how large funds can invest or the flow of institutional money into or out of individual positions.

 We have evidence of both beliefs here. stock prices often change immediately to reflect news about a corporation. Showing there's some degree of efficiency in the markets and stock bubbles, daily changes and prices and other fluctuations suggest there's some irrationality to the markets as well. Well investors from either camp may acknowledge both theories as being at least partially true, they will often favor one over the other. So those are how the two philosophies differ and you can see there are some fundamental discrepancies between the two. But why are investors so fearce to build this debate?

 Well part of it is that there's actually money on the line. Assets under management around the world continue to be primarily actively managed. But passive investing has put a dent in this and gained traction over time. especially, in the U.S. Part of the reason for this is that active investing tends to charge higher fees than passive investing. Active funds typically charge management expense ratios above 1% to compensate them for their research analysis and added trading. But passive funds can have fees below 0.5% meaning that for active funds to compete they'll need to earn additional return to make up for their higher fees at all tasks. 

There's also been a lot of research showing that active strategies don't guarantee out performance. In fact a number of research reports suggest that active mutual funds actually tend to underperform passive funds. But some active investors do contest such papers, arguing that active strategies and investors are too diverse a group to include under one category. For comparison purposes some funds after all are closeted indexers or face restrictions that affect their performance. so it might not be fair to deem these funds as representative of the active approach. not to mention that only public performance data is used when comparing strategies. meaning a large segment of the active investment market is left out of the analysis. Reports are also time sensitive and since passive funds tend to do better during general bull markets, the recent long rally in the u.s. is sure to affect results.

 But outside of arguments around research reports, active investors do have their own criticisms of passive investing. For one the approach is seen as rigid. Forcing the investors to buy companies that may be deteriorating or explicitly taking on too much risk at the expense of the investor. Passive investing also tends to have a bias towards large cap companies. Meaning investors only invest in new technologies after they've experienced their massive growth. Some investors have even suggested that the lack of analysis that comes with passive investing, can cause market irregularities inflating stock prices without any fundamental reasoning. although  those claims might be a bit larger than they should be. Needless to say both sides have some pretty nasty thoughts of the other. 

But here's the thing. As much as we love to view the system as  binary it really isn't. There are a lot of strategies that exhibit both active and passive traits, smart beta portfolios that passively invest in a constructive index based on what the creator believes to be superior factors, Stock pickers who hold their companies for the long term rather than trading on fluctuations. The truth is that investing strategy is more like a spectrum. At the one end you have extreme active where investors is trade daily and watch markets 24/7 and on the other end you have extreme passive: Where investors own literally every stock available. 

Neither these two forms truly exist and while investors identify as active or passive, they probably exhibit some degree of both philosophies. I for example am an active investor. I pick my own companies, but I hold positions for the long term regardless of the daily fluctuations. so regardless of where you fall in the spectrum, there are still lessons you can take from both approaches that will help you become a better investor.

 Firstly, look to lower fees where you can. Over the long term even half a percentage point can make quite the difference. Secondly try to avoid falling victim to your biases. overconfidence, hindsight bias and regret aversion are just some examples of mental shortcomings, that can plague both passive and active investors. thirdly, diversify. People disagree as to what extent you should spread out your holdings. But most will agree that you shouldn't put all your eggs in just a few baskets.

 And finally for most investors it's best to focus on the long term, unless you're trying to be a day trader. which is an extreme active practice not recommended for beginners. there's really no need to pay attention to the close fluctuations of the markets. if you have faith in your investments whether you picked them actively or passively. Then you should do well over the long term. 

Now this isn't to say that there aren't bad ways to invest. There are certainly terrible speculations and investment approaches. But at the end of the day there are plenty of professional, diligent and responsible investment approaches that are bound to do well for you over time.

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If you have any feedback or topics you want me to cover in  the future  leave a comment down below.