The difference between passive and active investing is not difficult to understand. But even so, my standard attempts to explain the concept usually cause my friends and family’s eyes to glaze over….
I hope the infographic above and the following explanation help clear things up a bit.
First, let’s take a look at passive investing.
A passive investment strategy is one that allocates an entire portfolio into stocks and bonds. The account stays 100% invested at all times, no matter what.
Market crashing? Stay invested. Market moving sideways and not earning anything? Stay invested. Zombie apocalypse? Stay invested!
There’s no such thing as pulling your money out and keeping it in cash. Instead, passive investors are betting on the theory that over time, they should be compensated for taking on market risk. This is called “market risk premium” or “beta.”
Sure, this strategy has a chance to succeed, but only if an investor can handle turbulent markets and truly stick with the “stay invested” slogan. And herein lies one of the biggest problems with passive investing. Staying invested turns out to be MUCH harder than it looks.
Most people without professional experience just don’t have the type of emotional strength to hold through rough markets. Instead, they pull their funds out at exactly the wrong time. Usually at the market bottom. And that is why they end up losing big with a passive strategy.
Remember 2000-2001? Or 2007-2008? Was that an easy period to sit through? Hell no.
Passive strategies force investors to deal with tons of volatility. You are stuck riding Mr. Market’s rollercoaster. But this isn’t the “fun” roller coaster you rode with your kids at Disneyland. In Mr. Market’s ride, you get to watch your life savings shoot down and up and down again, while you can do nothing but just try to hold on tight….
The goal in passive investing is to stay invested until retirement. You aren’t supposed to touch any of your funds before then. So unless you’re one of the lucky ones that gets to retire at 40, this is a pretty long time that your funds are in the market.
But there’s a big flaw to this strategy. It assumes that everything in the markets will be all hunky-dory when you retire. But how in the world could you know that? Unless you have some magic crystal ball of course. Hell, if you could predict the exact market conditions 10 to 20 years down the road, you would filthy rich and you wouldn’t be reading this article!
Think about those passive investors who were planning to retire around 2007-2008. Could they do it? Probably not. Their life savings were just decimated by the market crash.
So in reality, passive investing is just putting your savings into the market and then hoping and wishing things will be okay when you want to retire.
You’re a successful professional. In your experience, does “hoping’ and “wishing” alone ever produce good results?
Didn’t think so….
The main deficiency in a passive investment strategy comes down to its lack of risk management. The strategy doesn’t include plans to cut investments that aren’t working. Or protection from giant market crashes. Risk remains undefined. No one knows what will happen.
The only “risk management” a passive investment strategy has is the shifting of assets from stocks to bonds over an investor’s lifetime. As an investor grows older, a passive strategy usually moves more and more funds from equities to fixed income because they’re considered safer. This adjustment matches people’s risk tolerance which shrinks as they get older and closer to retirement. This does makes sense, but it’s still not sufficient protection. A higher allocation to bonds won’t save you from a giant market crash where all asset classes get hit.
There’s also no way to benefit off these inevitable market crashes. Passive strategies are long only. You can’t short anything to make a profit. And in our opinion, why tie one hand behind your back? Being able to short opens up tons of new opportunities!
What you end up getting in a passive strategy are small frequent gains over time, with large sharp losses every once in awhile. The strategy performs most of the time, but then gets decimated during market crashes. And in the end, the huge losses usually outweigh the gains depending on when you finally pull your money out. The investor’s account likely becomes net negative. And as explained before, most investors pull their money out at the exact wrong time which maximizes their losses.
So what’s the alternative to passive investing and its problems? It’s a little something called active investing….
Active investing is not an “allocation” strategy like passive investing. The money in an account isn’t just thrown into a predetermined mix and left up to the market gods. Instead, active investing involves careful analysis and the opportunistic deployment of capital. This means an active investor only puts money into the absolute best investments he can find. In situations where nothing looks good, an active investor does not invest. He just keeps his money in cash. In an active strategy, sometimes cash is actually the best investment.
You can think of the difference between active and passive investing as the difference between your kids’ peewee basketball league and the NBA. In the peewee league you have little kids closing their eyes, throwing the ball up, and hoping for the best. Whereas in the NBA, you have Steph Curry of the Golden State Warriors squaring up and taking only the best shots available with absolute precision. Which sounds more effective?
Take a situation like 2007-2008 again. If an investor is following an active strategy, he would exit the markets well before things went into panic mode. By pulling his funds out of falling stocks and keeping them in cash, he would avoid the huge volatile rollercoaster Mr. Market sent all the passive investors on. His cash would be sitting safe by his side as he slept like a baby at night.
There is no need for an active investor to tough out volatile and dangerous market situations like a passive investor. He has the option to not play, or in basketball terms again, not shoot. There’s no need to force the shot! An active investor doesn’t have to keep his money in the market the entire time. With this freedom his time in each investment ends up being much less compared to a passive strategy. Active investors can be thought of as fair weather friends, but in a good way. They are there for the good times in a market, but when things turn ugly….cya!
And unlike a passive strategy, an active strategy provides the opportunity to actually benefit from market drops. This is done through shorting. So not only does an active investor have the option to pull his money out of the market before things get rough, but he can actually ride the crash down and profit from it. He has a lot more flexibility and profit opportunity with an active strategy.
But all in all, the key benefit active investing provides over passive investing is risk management. In active investing, an investor always chooses a risk point or stop out where he will exit an investment no matter what. This practice defines risk on the trade, unlike passive investing where risk is undefined.
So, in the active style, with a $100k account, an investor may buy $60k worth of IBM stock. His plan would be to exit if the value of those shares fell below $59k. In this example, the capital at risk is only $1k. As soon as the value drops by $1k, he is out. The risk in this investment is pre-planned and defined. The investor chose to risk $1k and when things went wrong he lost exactly $1k. Plain and simple.
By investing passively, an investor buys a basket of stocks worth $40k and some bonds worth $60k. If the value of the stocks fall by $10k, the investor is still in the investment with a large loss! If the stocks fall another $10k, the investor is out a total of $20k! Notice the difference? The amount of loss to endure is undefined. It could be as low as $100 or as high as $20k. No one knows the amount of pain they’ll have to take. For most people, the uncertainty is more nerve racking than the loss itself! Uncertainty creates anxiety and sleepless nights and ultimately leads to most passive investors “throwing in the towel” at exactly the wrong time.
With active investing you get to determine exactly the amount you are willing to lose before taking a dip in the water. The “risk management” in passive investing doesn’t nearly compare. Sure more assets are allocated to bonds over time, but this isn’t enough. Over the same time in an active strategy, investments change based solely on opportunity and performance. Where is the best area I can risk a little to gain a lot? Are my holdings earning profits or going down? If something is losing money or not acting right, the investor has the power to exit and move on. He isn’t stuck holding the bag that’s been in the red for years.
Before Foundation, we too used to passively invest with undefined risk. We spent countless months hoping and wishing for investments to turn around and come back. The whole experience felt like subtle torture! But after making the switch to defined-risk active investing, those feelings not only disappeared, but actually reversed. Now our day to day carries much less anxiety and holds a lot more certainty because we know exactly how much we stand to lose if things go south. It makes life so much easier. Plus we get to forever avoid the dreadful conversation with the family on how the market took half our savings.
Due to strict risk management, active investors will experience frequent, tiny losses over time. But don’t worry, this is a good thing. It comes from all the stop outs that occur when an investment isn’t going in the right direction. Losers are cut right away, which is always a good strategy to avoid the BIG losses. But then, every once in awhile, an investor will run into massive gains. These come from the investments that not only work, but take off like the SpaceX Falcon rocket. These gains end up covering all the small losses plus much more and the investor ends up hugely net positive.
For capital preservation and safety, active investing is really the way to go. It’s all about risk management and it’s the key reason you won’t experience huge losses. All the risk is defined and your capital stays safe. Passive investing, on the other hand, will most likely hand you more than a few devastating losses over your lifetime. You just have to hope and pray that those huge losses don’t come at the wrong time and wipe you out just as you’re ready to retire.
At Foundation Investing, we understand how much better active investing is compared to passive investing. That’s why we use an active strategy called the Fusion Analysis Approach. Our goal is to achieve superior risk-adjusted returns. This means that we not only aim to out-perform a passive strategy, but to do it in a way that is much safer and less risky. We enjoy being able to give our family and friends the returns they deserve, along with the peace of mind that comes with knowing their money is as safe as possible.
We are also excited that our service is now open to the public too. If you’re interested in joining, just click here to learn more!
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