How to Invest Money Wisely: Active Vs Passive Methods

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Investing Money in Different Ways

There are many options to how we can invest our capital. We can leave it in the bank gathering interest; we can buy property to get a reasonable percentage rental return, or we can invest in the share market. This article summarises the share market option and how we may go about this safely to achieve financial returns.

Generally, there are two approaches one can take when investing in the share market. Firstly, we can invest in an ‘active’ way, where an investment company will actively manage our money to ‘beat the market’ and get better than average returns. Secondly, we can ‘passively’ invest, where a long-term (15-20 year horizon or longer) approach is taken to achieve ‘average’ returns in a low tax and low fees environment, with very little active management.

Watch Nobel Laureate William Sharpe on Investing

Nobel Prize in Economic Sciences

In 1990, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990 was awarded to three economists Harry Markowitz, Merton Miller and William Sharpe for their contribution to the body of work known as ‘Modern Portfolio Theory’ (MPT). The core theoretical premise of MPT is the ‘Efficient Market Hypothesis’ (EMH). EMH states that the market quickly and accurately reflects all available information, and therefore fair prices exist in the market for both buyer and seller. This means that the market is too efficient to allow investors (with an active management approach) to take advantage of share prices that:

  1. do not accurately reflect all available information or
  2. do not respond quickly to new information.

In essence, investors collectively have factored everything that is known about stocks into current prices hence, it is impossible to beat the market consistently by savvy stock picking. If investors do have additional information that is not available to the market and act on it, then this is ‘insider-trading’, which is illegal.

In the book The Only Guide to a Winning Investment Strategy You'll Ever Need , 2005 investment professional Larry E. Swedroe describes the crucial difference between 'active' and 'passive' mutual funds, and tells you how you can win the investment game through long-term investments. In clear language, he shows how the newer index mutual funds out-earn, out-perform, and out-compound the older funds.

Active and Passive Approaches to Investing

The argument is, that if the share markets are reasonably efficient, with all information available, then everyone has an equal chance of succeeding (making financial returns). However, the strategic approach to making these returns differs in terms of the method chosen i.e., an active or passive strategy.

To take an analogy from tennis: the active management approach is the player who is going for the ‘ace’ shot every time; the passive investment approach is the player who is going for an average shot every time. Over the long term, the average player, who is hitting the ball back, with a bit of pace and utilizing the middle of the court will win more often than the player whose strategy is only to make ace shots.

It is simple to see why this is the case, in that the probability of hitting an ace shot, every time, is extremely low. Active investment managers, in effect, are trying to hit aces on a consistent basis. Every now and again, they will hit one and this corresponds to a particular managed fund achieving an above average return for a particular financial year. However, in doing a historical analysis, you would generally never see the same investment manager consistently achieving above average returns year in, year out.

To stretch the analogy a little bit further, the tennis ball is the information and both players have the same information (according to the EMH) when playing the game. Therefore, the game strategy is the key difference between the two players (the active and passive approaches) and not the ball. If the player, who prefers hitting aces was to alter the rules of the game, say, by replacing the ball so it would somehow increase the probability of hitting aces (obtaining information that the market does not have), then this equates to insider trading, which is cheating. Fortunately, there are referees in the share market, as well as in the game of tennis to prevent such behaviour. Thus, we are once again left with the same playing field (the efficiency of the markets) and it is solely the strategy we take which determines whether we are successful or not.

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Index Funds

A passive investment approach is achieved by investing in the share market through what are called ‘Index Funds’. These are shares (grouped together in a fund, across many sectors) that match or track a share market index. A share market index, for example in New Zealand, is the NZX 50, which is a barometer of how well the New Zealand share market is doing. In America, for example, you have the Standard & Poor’s 500 Index (S&P 500), which again gives an indication of how well the American stock market is doing.

Historical analyses show that these share market indices consistently rise, over many decades, despite relative increases and decreases in the share market over this time. Thus, index funds, which track the movement of these indices will, over the long term (despite the ups and downs of the share market), reflect these rises. Consequently, financial gains are made over the long term when taking a passive investment approach through investing in Index Funds.

Additional advantages of an Index Fund are that they provide broad market exposure, low operating expenses and low portfolio turnover. Financial returns are achieved, over the long run, specifically through:

  • Lower management fees being charged due to fewer transactions being made;
  • Lower taxes;
  • Diversification of investments (i.e., selecting a portfolio of stocks in order to produce the maximum potential returns given the amount of risk an investor is prepared to take);
  • Periodically rebalancing your portfolio.

In contrast, active management incurs greater fees because more transactions are made, resulting in more taxes, as well as returning inconsistent results, which eat into financial returns. Thus, over the long-term (e.g., 15-20 years or longer) passively managed Index Funds consistently outperform actively managed funds on the share market.

Summary

In summary, a passive investment approach is better than an active management approach because:

1. the market is efficient, allowing for the provision of accurate and up-to-date information for both market buyers and sellers;

2. costs are minimized that would otherwise detract from your returns;

3. a long-term and well thought out investment strategy (diversification) provides greater returns than trying to consistently beat the market (which is impossible).

Article Co-authored with Dr S. J. Webber

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