U.S. stock markets can be a frenzy of activity. There is no shortage of people on TV with a lot to say about where the market is headed and why. However, very few of them have the ability to predict market movements with accuracy and consistency. This makes the ongoing debate regarding active vs. passive management a very important one that individual investors need to carefully consider. Despite the profit potential of owning and trading individual stocks, fund flow data and recent performance results indicate that limiting your portfolio activity and focusing instead on keeping your costs low may yield better results.
Defining Active vs. Passive Investing
To understand why limiting your portfolio activity may be the more attractive option, we have to start by understanding the terms. Active investing is exactly what it sounds like: the investor constantly updates his/her portfolio with a series of sales and purchases. The active investor also monitors all sorts of economic and political factors and tries to exploit—and profit from—inefficiencies in the market.
Passive investing is quite the opposite. The investor has considerably more limited interaction with his/her portfolio, focusing less on market timing and more on consistent, routine investing. The only semi-active strategy that may be acceptable to an otherwise passive investor is rebalancing, a process which is often automatic and designed only to return a portfolio back to its target asset allocation. Beyond that, passive investors leave their investments mostly static with the belief that the long-term growth of the market can act as a sufficient buffer against short-term volatility.
The Cost of Active Investing
There are a few ways in which employing an active strategy can cost you money. The first is through transaction costs. If you're trading in and out of stock positions on a daily or weekly basis, you may be incurring a cost each time you place a trade. Over time, the collective cost of those trades must be overcome by strong performance to make them worthwhile. Trading costs have come down over the years, but depending on your level of trading activity, those costs can still add up.
Management fees are another cost of active investing. Management fees are charged by a variety of financial service providers ranging from financial planners and investment advisory firms to the vast universe of mutual fund providers who utilize active management rather than an index approach. John Bogle, the founder of Vanguard and a leading proponent of passive investing, estimates that the cost of active money management averages 2.27 percent a year. As he says, “If we assume a real stock market return of, say, 4.5 percent, the active parasite consumes 50 percent of that annual return.” This is opposed to a potentially small fraction of that cost when utilizing a passive strategy. Even a 1% annual cost can make a big difference in the long run because, as Bogle points out, you are paying for these costs in current dollars, but your investment will be affected by inflation, further increasing the amount you pay.
Implement a Routine, Systematic Process for Investing
The performance data shows that active managers haven’t been keeping pace with market indexes, especially in the past few years, during which the U.S. stock market has performed well. Active management requires more time and attention dedicated to market news along with potentially higher trading costs and management fees.
Utilizing a routine, systematic process when purchasing investments can help people buy securities at random prices over time rather than going through the often frustrating experience of trying to accurately predict future market moves. If you have a longer time horizon, that could work in your favor, as markets have always moved up in price over long periods of time, as evidenced by the fact that all of our major stock market indexes are currently sitting at or near their all-time highs. Purchasing low-cost investments such as index mutual funds and ETFs can further enhance your performance by avoiding the increased costs associated with active management.
You probably work hard for your money. Take a moment, assess your investing strategy, and make sure your money is working equally hard for you.