In the financial services the realm, the issue regarding the efficacy of active versus passive investment management is divisive. While some investors and money managers might recognize the merits of each strategy and leverage a plan to optimize the best of both, in most cases, the preference is clear-cut. Kind of like asking someone whether they prefer Coke or Pepsi products – their choice is usually cemented in stone.
Here we break down the definition of active investment management and passive investment management and consider the benefits and drawbacks of each. Ultimately, the decision to elect one over the other, or blend the two, is personal and depends on an individual’s comfort with the market, risk tolerance, and overall financial goals.
Your A-Game – A Look at Active Investment Management
If you prefer active investment management, you have likely made the decision to partner with a wealth management firm, or individual financial planner to help manage your investments. Whether you have the full support of a team, or rely solely on one trusted advisor, the key to active investment management is the human element. Emphasizing statistical data, forecasting, and reaction to market activity, whether gains or losses, active investment management is dynamic and can change on a dime. It’s designed to do so.
Instead of leveraging index funds, which are mutual funds supported by a portfolio created to follow the market index, like the S&P 500, active investment management requires the buying and selling of individual stocks. Why is this a good strategy?
For a few reasons…
- Quality Control.
By buying and selling individual stocks, an investor can choose
only those that will support financial goals like return on equity, profit, liquidity, and leverage.
- Risk Management.
The ability to buy and sell individual stocks translates as the ability to avoid particular industries or companies, thereby minimizing any perceived risk.
- Increased Efficiency.
By managing stocks in taxable accounts, investors are able to offset capital gains by deducting capital losses.
In light of all this control and efficiency, what’s the catch?
Simply put, the risk comes down to individual company performance. In other words, if one company’s stock suffers a decline, investors will feel the effect more acutely than in a passive investment management scenario. Taking the active investment management route also means that investors incur increased expenses associated with trading costs. And, remember that human element? Yeah, he or she needs to get paid.
The Passive Position
Passive investment management, also referred to as “buy and hold investing,” involves the long game. Unlike active investment management, investors cannot be reactionary or waste time wishing for a crystal ball to forecast the future. The name of the game with passive investment management is patience.
Remember those index funds? Well, the beauty of those is big and broad. Index funds cast a wide net for maximum market exposure to a variety of industries and companies. As a result, passive investment management requires reduced operating costs, and decreased rates of portfolio turnover.
Regardless of market activity, these index funds follow stringent guidelines and, as a result, are more static in nature than the dynamism inherent in active investment management strategies.
Great, so why would any investor commit the considerable time, money, and effort to actively investing? Because passive investing has its pitfalls, too.
Particularly problematic is the possibility of sector-specific investment concentrations, which puts investors at greater risk for loss. Another reality that needs to be considered is the fact that passive funds are not designed to outperform stocks – only follow them. And, no matter what, passive stocks are at the mercy of the market as a whole. So, if the NASDAQ suffers a hit, for example, shares will drop as well.
Surely, you’ve heard that expression, “Teamwork makes the dream work.” Well, in this case, envisioning a two-pronged financial plan that leverages both active and passive investment management strategies could bring you closer to realizing your goals. Unsure how to move forward? Be sure to ask your financial advisor for advice that is appropriate for you.
REMEMBER! If you have any questions regarding how this topic relates to you or how it may affect your investment portfolio or financial plan, do not hesistate to contact your financial advisor today. Not yet working with Moneywise Wealth Management? Contact us for more details on how we can help you get your financial house in order. We’re here for you! 661-847-1000 or firstname.lastname@example.org
The Moneywise Wealth Management Team
*Content is sourced by and courtesy of Chatterton + Associates.