There are some age-old debates that may never be settled. Did the chicken come first or did the egg? Is pineapple good on pizza? Is Tupac still alive? One of the biggest age-old debates in the financial world is whether or not active investing is better than passive investing, or vice versa. In this newsletter, I am going to define passive and active investing, explain the differences between the two, and give my thoughts on which type of investor you should be.
Active investing is just what it sounds like, investing actively. Managers of actively invested money frequently buy, sell, and trade stocks, options, and other securities. The goal of an active investor is to beat the market. Active investors believe they can consistently choose investments that outperform the major stock indexes. To do this, you would obviously need to be smarter than the average investor and be able to see into the future (which requires a combination of skill and luck).
There are two different types of active investors; 1.) You primarily invest in actively managed investment funds or 2.) You invest primarily in stocks of your choosing and frequently buy, trade, or sell. If you’re the first type, to be successful you need to pick fund managers that consistently beat the market. Standard and Poor’s annual SPIVA Scorecard shows that over the long-term, such as 10 or 15 year periods, 80% or more of active managers across all categories underperformed their respective benchmarks. Market Watch reported only 1 in 20 actively managed domestic funds beat index funds. The chances of picking an active manager who consistently beats the market in the long-term are not good.
If you decide not to invest in actively-managed mutual funds and instead want to pick your own stocks, your chances at beating the market are probably worse than professional fund managers. Managing funds is a full-time job, and even managers with decades of experience struggle to beat the market. Beating the market requires anticipating changes in the economy before they happen, and timing the market is a very difficult, if not impossible task.
Passive investing doesn’t require any special knowledge; you don’t need to be able to see into the future, or time the market. To be a successful passive investor, all you need to do is invest consistently and hold your investments for long periods of time. Passive investors are very disciplined, and do not make decisions based on emotion or market sentiment. More importantly, when the market is on the way down they don’t sell, they keep investing all the way to the bottom. And then they invest more all the way back up to the top. Passive investors are driven by the belief that in the long-term, the market will always go up.
Lately, fear has dominated the financial news cycle. The CNN Fear & Greed Index classifies current investor sentiment as “Extreme Fear.” There are trade wars, inverted yield curves, and federal rate cuts. The fear of a looming recession might be the highest it’s been since the housing crisis. So what if we have another recession as bad as 2008?
The fear of a recession costs investors far more money than actual recessions. Take 2008 for example; by March 2009 the S&P 500 was on the way back up again and another bull market began; by April 2013, the S&P 500 was setting new record highs. So if you were a passive index fund investor who stayed in the market and kept investing, you came out looking very nice at the end (although it was a very rocky ride). If you took your money out of the market at the height of the Great Recession, you might never fully recover.
In case you couldn’t tell already, I’m a fan of passive investing. Trying to beat the market is a dangerous game to play and most of the time you will lose. However, I still believe in buying penny stocks or options contracts on Robinhood if that gives you joy and excitement. Just look at it like buying a lottery ticket. Although if you have a gambling problem, you probably shouldn’t be buying lottery tickets or penny stocks (and definitely not options contracts).
Thanks for reading today’s newsletter. If you have any questions, comments, or suggestions for topics you can e-mail me at firstname.lastname@example.org.