If you are investing, whether on your own or through an advisor, you must make an important decision about this question: Can you beat the market?
For those that hope to or expect to do better than the market, they choose active investing. Those who don't believe that they can consistently beat the market choose passive investing. Passive investing is investing in an appropriate set of indices, like the Standard & Poor's 500. The good news for passive investors who make only market returns is that they can pay very low fees.
Active investors often don't fulfill their goal of beating the market, and they pay higher fees or spend a lot more time investing than passive investors.
Active Investing
Active investing is an old tradition! The idea is to beat the market. For many people, the idea is just to make money. If the market goes up 20% and they go up only 15%, they are still happy with the gain.
People couldn't invest passively until the 1970s, when John Bogle of The Vanguard Group formed a fund. Most investment professionals try to beat the market, though passive investing has gained a lot of traction in recent years. Still, the majority of investing is done this way.
To pick your own stocks is very demanding! To be fully informed takes a lot of time. Besides watching the prices of securities and executing trades, an active investor needs to do research or have access to it and review it. Otherwise, it's simply gambling. Even with a big investment of time, success can be difficult to attain.
Finding good active managers is challenging as well. Hiring someone means a large payment of fees, which can eat into the returns. Worse, while investment professionals are smart, they aren't always that good. In fact, the industry typically underperforms the indices. The New York Times ran an article about mutual funds on December 2nd:
Despite the facts, the game of trying to beat the market is still very actively played. "While it’s possible to beat index funds, it’s not easy to do over the long run, and as Paul Samuelson, the first American to win the Nobel in economics said in the 1970s, it isn’t worthwhile for most of us to try."
Passive Investing
Passive investing is a newer concept than active investing, but I think that for many people it makes sense. It can result in lower fees and better performance, though passive investing can't beat the market.
I think that anyone can paint, but there are few very strong painters. Most people don't decorate their houses with their own art! Similarly, anyone can invest, but there are few strong investors. Passive investing is a disservice to anyone that is truly good at investing. Someone who can pick stocks very well should do so!
For do-it-yourself investors who want to use passive investing, the objective is to identify the goals and to find providers that can help with the index investing. The factors that impact the goals are many, but the ones that stand out are age and tolerance for risk. For many people, the stock market is simply the Standard & Poor's 500 index, which measures the largest companies. There is an S&P 100 index that measures the top 100, and there is also an S&P 400 or S&P Mid-Cap, which measures the next 400 stocks after the 500 largest ones. There is also an S&P 600 0r S&P Small-Cap that measures the next 600. These are just 1500 stocks, and there are even more on the NYSE and the NASDAQ. There are other indices too, with FTSE Russell being a popular provider.
For many American investors, the S&P and Russell indices cover things, but there is an entire world out there. Many passive investors broaden their target to include stocks from other countries, even emerging countries.
Once you have an index or set of indices to beat, how can you invest? You can hire a manager through a mutual fund, or you can buy an exchange-traded fund (ETF). These tend to be low-fee options. If you hire an active manager, they may use only these types of assets and charge you a fee for other services.
When people ask me who I recommend for investing, the top of my list is Vanguard. My wife's IRA is there, and we invest in a charitable fund there too. Her IRA is invested in passive funds primarily, though she does add a few stocks too. The charitable fund is entirely passive. Vanguard was a pioneer of passive investing, and I think they offer a lot. I didn't learn about donor-advised funds until just a few years ago. Here is Vanguard's explanation of them, though I am aware of many providers.
Which Is Better?
I am an active investor, but I sure appreciate passive investing. I think that I can and do beat the market, but I sure spend a lot of time doing research! For most people, passive investing makes more sense. The fees are lower, and the performance is very close to the goal. The strategy of "beating the market" is pursued too frequently, in my view, and most professionals fail. It's even harder for individuals!
Conclusion
Are you going to be an active investor or passive investor? This is something you need to decide for yourself. I am both! I do believe that active investing can make sense for some folks, but passive investing is likely the right choice for more folks than are using it currently.
The most important problem to solve is investing rather than not investing due to lack of understanding about how investing works. Whichever route one takes, one can learn to be a better investor. Active investors can learn how to make better decisions and to limit risks more appropriately. They can also learn how to pick better advisors. Passive investors can learn more about better managers and about the best long-term strategies for investing. No matter which route one takes, it's important to watch the fees you pay.
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