Active Vs Passive Investing Debate
Are you actively involved in investing? Do you believe that you can outperform the market over time? It's widely known that, on average, active mutual funds tend to underperform index funds.
Or maybe, you invest passively. Only someone lacking common sense would claim that the markets are completely efficient. Okay, perhaps that statement goes too far.
The truth is, the active versus passive debate can become quite heated among investors.
While most investors agree on the importance of investing for personal finance, they can't seem to reach a consensus on the best approach.
On one side, active investors believe that passive investors are lazy and oblivious to market irregularities.
On the other side, passive investors criticize the high fees and arrogance of the active investing crowd.
Although it's easy to poke fun at this argument, it is crucial to understand the differences between the two strategies in order to determine your own approach when it comes to investing.
So, let's delve into the active versus passive debate and explore whether these two sides can find common ground on today's discussion.
Important Clarification
Before we start, it's important to clarify that the intention of this discussion is not to disprove either school of investing.
As someone who has experienced both passive and active investing, I believe that both approaches have their merits.
While some individuals staunchly argue that there is only one correct way to invest, I do not subscribe to that belief.
With that said, it is crucial for beginners to understand the active versus passive debate.
Although I have my own biases, my goal is to present the argument in an impartial manner so that you can gain an appreciation for both sides.
Definitions
So, let's start by defining what it means to invest actively or passively.
It's worth noting that the exact definitions may vary depending on who you ask, but here are the key characteristics of each approach:
Active Investing
Active investing involves actively monitoring the prices of your investments to identify buying and selling opportunities.
Investment decisions are based on research or analysis, and the portfolio's objective is often to outperform a specific benchmark.
A benchmark can be an index or a combination of indices that serve as a reference point for the overall performance of the stock market or a particular market segment.
The excess return an investor achieves over their benchmark is referred to as alpha.
Therefore, active investors strive to generate alpha when making investment choices.
There is a wide range of active strategies, some of which may even offer conflicting views on individual positions.
However, this is the broadest definition of the active investing philosophy.
Passive Investing
Passive strategies, in contrast, do not place emphasis on short-term fluctuations in stock prices.
Instead, investors in passive strategies simply buy positions as they have available funds or when they decide to include the position in their portfolio.
Passive investing also involves minimal to no research or analysis of individual companies.
Instead, investors focus on spreading their investments across a wide range of stocks to achieve diversification and gain exposure to the overall stock market.
In this way, passive investing does not seek to outperform the benchmark but rather aims to replicate its performance.
There are various approaches to passive investing, but one of the most popular applications is index investing, which has become synonymous with the passive investing philosophy.
Index investing entails purchasing index funds that directly track an index.
Since indices are considered proxies for the overall stock market or specific market segments, investing in an index provides broad exposure to the performance of stocks.
Passive vs Active
So, these are the two primary approaches to investing:
one focusing on analysis and valuation to achieve the alpha, and the other on diversification and long-term market exposure.
The Case For Passive Investing
But why don't passive investors also aim to earn alpha?
The reason lies in how passive investors perceive the market and the capabilities of individual investors.
Passive investors largely adhere to the efficient market hypothesis (EMH), which was developed by Eugene Fama in the 1960s.
According to the EMH, a stock's price at any given time reflects all available information and trades at its fair value.
This implies that investors are unable to consistently identify stocks that are overvalued or undervalued, as all stocks will eventually trade at their intrinsic value.
With numerous traders actively participating in the market, conducting research, and seeking new information, the collective buying and selling actions should bring stock prices close to their actual worth.
Passive investors who adhere to the efficient market hypothesis believe in this concept of market efficiency.
The Case For Active Investing
Active investors, however, do not believe that markets are entirely efficient.
They contend that stock prices can deviate from their intrinsic value, and through research and analysis, one can identify these opportunities.
One of the core tenets of this belief is the existence of investor irrationality.
While the efficient market hypothesis assumes rational behavior from all investors, active investors argue that market participants often exhibit irrational behavior influenced by behavioral biases that can override logical decision-making.
Other factors, such as investment mandates that restrict the investment choices of large funds or the impact of institutional money flowing in or out of individual positions, can also affect market efficiency.
The evidence supports both perspectives to some extent.
Stock prices often react quickly to reflect news about a company, indicating a degree of market efficiency.
However, the presence of stock bubbles, daily price fluctuations, and other irregularities suggests irrationality in the markets.
While investors from both sides may acknowledge the partial truth in both theories, they tend to lean towards and favor one approach over the other.
Why Fight Between Active vs Passive
So, these are the key differences between the two investment philosophies, and it's evident that there are significant disparities.
But why do investors engage in this debate with such fervor?
One reason is the financial stakes involved.
Globally, the majority of assets under management are still actively managed, but passive investing has gained traction over time, particularly in the United States.
One contributing factor to the rise of passive investing is the lower fees associated with it.
Active funds typically charge management expense ratios of over 1% to cover the costs of research, analysis, and trading, whereas passive funds can have fees below 0.5%.
Consequently, active funds must generate higher returns to compensate for their higher fees in order to remain competitive.
Furthermore, numerous research studies have demonstrated that active strategies do not consistently outperform passive funds.
In fact, several reports suggest that active mutual funds often underperform their passive counterparts.
However, some active investors challenge these findings, arguing that the category of active strategies and investors is too diverse to be lumped together for comparison purposes.
They contend that certain funds may secretly track an index or face restrictions that impact their performance, and thus, it may not be fair to consider them representative of the broader active approach.
Moreover, it's important to note that only publicly available performance data is utilized, leaving out a significant portion of the active investment market from the analysis.
These reports are also time-sensitive, and the recent prolonged bull market in the United States is likely to have an impact on the results, favoring passive funds.
However, beyond the arguments surrounding research reports, active investors have their own criticisms of passive investing.
Firstly, the passive approach is seen as inflexible, as it obliges investors to buy companies that may be in decline or taking on excessive risk, neglecting the individual investor's best interests.
Additionally, passive investing tends to have a bias towards large-cap companies, meaning investors only participate in new technologies after they have already experienced significant growth.
Some investors have even suggested that the lack of analysis inherent in passive investing can contribute to market irregularities and create unjustified fluctuations in stock prices.
Nevertheless, it is worth acknowledging that both sides harbor negative opinions about each other.
However, here's the catch:
as much as we tend to view the system as binary, it is far from it.
There are numerous strategies that exhibit traits of both active and passive approaches.
For instance, smart beta portfolios passively invest in a constructed index based on factors believed to be superior by the creator, while stock pickers focus on long-term holdings rather than trading based on short-term fluctuations.
Investing Lies On A Spectrum
In reality, investing strategies lie on a spectrum rather than being confined to extreme ends.
At one extreme, you have highly active investors who trade frequently and closely monitor the markets 24/7.
At the other extreme, you have extremely passive investors who aim to own every available stock.
However, these two extremes rarely exist in their purest forms.
Most investors, even those who identify as active or passive, exhibit a blend of both philosophies.
For instance, I consider myself a passive investor as I love investing in index funds, but I also cherry pick some individual stocks which I love.
Regardless of where you position yourself on the spectrum, there are valuable lessons to be learned from both active and passive approaches that can enhance your investment journey.
Firstly, it's important to seek out lower fees whenever possible, as even a small reduction, such as half a percentage point, can have a significant impact over the long term.
Secondly, try to be aware of and avoid falling victim to biases. Overconfidence, hindsight bias, and regret aversion are examples of cognitive biases that can affect both active and passive investors.
Thirdly, diversification is key. While opinions may vary on the extent of diversification, most agree that it's unwise to concentrate all your investments in just a few assets.
Lastly, for the majority of investors, focusing on the long term is advisable. Unless you're pursuing day trading as an extreme form of active investing (which is not recommended for beginners), there's no need to be overly concerned with daily market fluctuations.
If you have confidence in your investments, whether chosen actively or passively, you should see positive results over the long term.
Now you shouldn’t mistake this and think that there are no bad ways of investing.
While there are certainly poor investment approaches and speculative strategies that should be avoided, it's important to acknowledge that there are also numerous professional, diligent, and responsible investment approaches that have the potential to yield positive results over time.
- Ivan