Passive vs active investment

Imagine if you will the only available investment opportunity is to invest in shares of sandal manufacturers. You are presented with two options. Option 1 is to take a long-term buy and hold position in a fund which holds interests in the top 100 sandal manufacturers in the world. Option 2 is to constantly buy and sell out of individual sandal companies like Birkenstock (if you were ever so foolish), and to try to time your investments to turn a quick profit. Option 1 is what we call ‘passive investment’ and Option 2, ‘active investment’. Strap in for the most exciting debate in the world of finance.

Passive investment

There’s a super cool concept I recommend you bring up at parties called CAPM, the Capital Asset Pricing Model. I always do and I’m a big hit. It looks something like this:

ERi = Rf + βi(ERm – Rf)

Scary right? I’m not going to bore you with the details. Passive investment is a long-term investment strategy where you essentially bet that in the long-run, buying and holding securities and minimising trading as much as possible will deliver you a decent return. This logic checks out, especially if like most passive investors, the securities you’re buying and holding are index funds such as ETFs (see Diversification and ETFs). Over the long-run the market performs well, very well. Couple that fact with the magic of compound interest (see The time value of money) and a passive investor is a savvy investor.

Active investment

Okay so you’re a couple of drinks in, the dance floor is buzzing and all your CAPM chatter has made you the life of the party. Now you understand why I’m kind of a big deal in most social circles. What next? Well naturally you hit them with this bad boy:

ERi = αi + Rf + βi(ERm – Rf)

Before you know it everyone is inviting you to their shindigs. They all pull out their phones and ask you for your Instagram handle – I’m obviously speaking from personal experience. Take a close look at the two equations above and spot the difference. Active investment is a desperate search for ‘Alpha’. Alpha is the holy grail of investment. Alpha is good. Alpha is gold. Alpha is really, really difficult to find. Your job in your search for Alpha is to look for investments which you think will outperform the market.

There can only be one winner

In 2008 the Oracle of Omaha, Warren Buffet bet a hedge fund US$1 million that after accounting for all fees, costs and expenses, they couldn’t outperform an S&P500 (largest 500 listed US companies) index fund. The hedge fund lost the bet. Think about that. The sole purpose for the existence of this hedge fund is to outperform the market and deliver superior returns (preferably net of all fees, costs and expenses). Now it’s not because the hedge fund is incompetent. The equity analysts who work at hedge funds are usually incredibly smart individuals with a wealth of experience behind them. It’s just that like I mentioned above, Alpha is difficult to find, and especially difficult to find consistently.

Another reason active investment typically loses out to passive investment is because it’s expensive. Warren Buffet said after accounting for all fees, costs and expenses. Passive investment is super cheap. You can buy into a market ETF with fees less than 0.5% of the value of your holding per year. Active fund managers on the other hand often charge high management fees as well as very expensive performance fees (which means that for every $1 they outperform their targeted benchmark, they take X% of the profits over that benchmark, that X% sometimes being as high as 20%).

Active investment also often loses out on a $ return basis. Most people (including yours truly) aren’t willing to bet everything they have on a single, risky stock. So they invest a smaller portion of their wealth in individual assets and pool together a larger sum to invest in an ETF (with real property being the exception given property investment requires so much upfront capital). I personally have invested in individual companies which have delivered in excess of 1,000% return. However I’d only invested a small fraction of my net wealth in these companies. On the other hand the ETFs I’ve invested in, which can’t hold a candle (on a % basis) to the returns on my market darlings (finance jargon for stellar stock performer), have yielded me much more in $ value because I feel they’re safe enough to deserve a more sizable fraction of my net wealth.

How can I actually take action

Active investment is obvious – simply pick an asset or business you think will outperform after you’ve done your DD. If you’re purchasing shares in a publicly-listed company you can do so via a stockbroking platform such as (and I have no commercial affiliation with the following): CommSec, CMC Markets, IG Markets, SelfWealth, Robinhood etc. If you’re purchasing real property you’ve likely engaged or will soon engage a conveyancer or solicitor to handle the transaction. Passive investment is even easier. There are a number of organisations which offer products that give you exposure to market indices (e.g. S&P500, ASX200). Two of the biggest (and I have no commercial affiliation with either) are: Vanguard and Blackrock. Many of these products trade on securities exchanges (like the ASX or NYSE) so you can purchase units the same way you would shares via the stockbroking platforms noted above. You simply need to peruse their products, read their PDSs, pick whichever you like best and punch in the ASX code into your CommSec or CMC account.

Fun fact – well I mean I think it’s fun

Statistically-speaking, women are better investors than men. Men tend to favour active investment. They believe they can outperform the market and like to invest in individual stocks. From a probability perspective they are much more likely to be wrong than have accurately chosen all the market darlings. Women on the the other hand tend to opt for the smarter, tried and tested route – passive investment, and deliver superior returns in the long-run. We are obviously generalising here guys – there are plenty of passive male investors and active female investors out there.

Takeaway

Whether you try your hand at active investment or take the more long-term passive approach will depend on your risk appetite, a concept we discussed in Diversification and ETFs. Most of us will try both at some point within our lifetimes. You are already likely a passive investor if you have a superannuation or 401k balance as that money is typically invested in a diversified portfolio which will usually include some market ETFs. The investment funds responsible for superannuation and 401k investment strategy traditionally take a buy-and-hold long-term approach, a passive strategy by definition. Buying an investment property on the other hand will make you an active investor since you’re making an investment decision (similar to picking out an individual stock) which you believe will outperform the market (i.e. higher growth in suburb median value over time and potentially higher than average rental yield). As with all things, do your research first and figure out which approach is most appropriate for your risk appetite.