A BEGINNER'S FINANCIAL GUIDE FOR A RICH LIFE

PASSIVE VS. ACTIVELY MANAGED INVESTING

Knowing the difference between active and passive investing will play a tremendous role in building wealth, as it will save you thousands of dollars over a long-term horizon. Active investing refers to a methodology whereby time is spent researching individual stocks that will make up your investment portfolio, over time these individual stocks will be churned in hopes of finding better investment opportunities.

money photoOne of the issues with active investing is the cost, transaction fees, or expense ratios if you are invested in a mutual fund. Also, diversification can be an issue as it will cost money and time to purchase the perfect stocks.

Passive investing, on the other hand, is a methodology that does not require constant churning, or tweaking as often as active investing. The best way to be a part of passive investing is by purchasing into index funds.

There are various funds which have been setup up to track the performance of the following indexes: S&P 500, Total Stock Market, Total Bond Market, Sectors, International Markets, etc. By investing in index funds that track the S&P 500, you essentially enjoy the performance of the publicly traded companies listed on the S&P 500. These funds are designed to offer diversification, as well as market returns.

At an average, the performance of the S&P 500 will outperform the performance of the majority of stock traders, and investment gurus. The issue is that many of these professionals have failed to outperform the market year over year. One year they may outperform the market and the next they underperform. By investing passively, and in index funds, you essentially set up yourself up to realize market returns, diversification, and free time that would otherwise have been spent researching and learning about individual stocks.

The best part of passive investing using index funds is their low expense ratio; many of the funds will have an expense ratio of 0.05% to 0.40%. While actively managed funds will have expense ratios of 0.5% to 1.5% although this may not seem like much of a difference, it can sure add up to a lot of money over a 10-year or a 20-year period.

Consider the fact that if you invest $10,000 into a fund that earns you a constant 8% return year over year for the next ten years, the difference between having your money into a fund with an expense ratio of 0.25%, and one that charges 1.0% is around $1,500. Your account would have $1,500 less at the end of the 10-year period if your money were invested in a fund with an expense ratio of 1.0%.

The $1,500 less is around 7% lower at the end of the period; this demonstrates the impact that fees can have on your investment portfolio. My calculation was done in a decade; it’s much higher over a 20-year, or even a 30-year period. $1,500 may not seem like much when considering the time range. However, this fee could be higher if instead of investing $10,000, you invested $50,000, or even $500,000.

Bottom line, pay attention to your expense ratios as they can add up to a lot, and that any individual can start investing utilizing the passive methodology, and do well.

Passive investing is about beating 80% of investors while putting in only 3 to 5 hours of work a year.

It may sound improbable but it is definitely possible – you can beat 80% of investors while trading only 3 to 5 hours a year. The simple strategy you can use to achieve this is called passive investing. Some describe this investing strategy as a ‘couch potato strategy’ since it essentially involves buying and holding securities for the long term.

‘Passive Investing’ is in essence index investing where buying a share of the index fund allows you to own a broad spectrum of securities representative of various asset classes. It allows you to capture the returns of the whole market, which means it doesn’t matter if one or several securities are lagging the market. What matters is making money over time from the collective return of all the assets that were pooled together into the index fund.

All you need to do after carefully selecting your basket of securities that will make up your passive investment portfolio is to just leave them there to appreciate in value through the years. But make no mistake about it because it is definitely not a ‘set it and forget it’ kind of thing. You need to review your portfolio regularly within a year to make sure the original weight you gave each asset class security remains the same. Changing market conditions may necessitate rebalancing your portfolio, which should take at least 3 to 5 hours each year.

So, how does this beat 80% of investors?

As discussed in an earlier chapter of this book, the vast majority of investors (80%) are actively managing their investments. They believe the market is inefficient and it does not immediately factor every market development into the price. That is why they are in constant search for undervalued securities so they can gain from possible short term price movements. In other words, they are timing the market hoping to generate better than market returns.

For varying reasons, these unfortunate investors have stubbornly stuck to their habit of constantly searching for undervalued securities and timing the markets. Sadly, history has always proven them wrong as evidenced by the fact that the returns they manage to get consistently lag the market year after year after year. Only about a little over 20% of them manage to beat the market occasionally.

It would then be easy to outperform the vast majority of these investors who actively manage their investments. How? By being a ‘couch potato’ investor – by taking the opposing view and going long term. This is exactly what passive investing is all about.

Passive investing (in contrast to active investing) is founded on the theory that the market is efficient. It factors all and every market development into the price without delay. This means there is no way a security will be undervalued or overvalued at any given time as current prices already reflect the security’s fair value.

Over time, a security is bound to accumulate value. This puts to rest the argument of an inefficient market which all active investors adhere to – in short, there is no more need to actively buy and sell securities.

There are three main benefits of passive investing:

It provides near-market returns.

It makes portfolio diversification easy.

It costs less than any active investing strategy.

As the securities market gets more and more efficient information with the advent of new technologies, active investors will find it more difficult to make money. Passive investing, on the other hand, can be expected to continue outperforming active investing over time. Meanwhile, stock picking will slowly become a thing of the past.

 

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