Getting Started With Investing – Active Vs. Passive Management

Before you dive into investing it is important that you understand what type of account to invest through. The investment vehicle that you are going to be taking on your journey to financial freedom is a very important piece of the overall puzzle. Make sure you first take the time to find the best account for you ahead of  getting started with investing.

After you have established the best account to use you can deposit money and get ready to invest! This is exciting because there are multiple steps you need to take before this point like establishing an emergency fund and paying down your debt. The worst thing you can do is invest to soon and then end up pulling your money out of the market at the wrong time or face paying hefty fees by withdrawing from tax advantaged accounts. If you are investing in a 401(k) your options will be limited to the plan that your company has provided. However, if you are investing in an IRA or taxable brokerage account you will have many options. You have the power to invest in any public company listed on an exchange. So, what is the best way to go about this?

Active Management

The first way you can invest is to pool your money with others and have professionals invest for you, an example of this would be a mutual fund or a hedge fund. In this scenario, you are counting on the management team of the portfolio to invest wisely and hopefully return your principal (the money you invested) with high excess earnings over the years. Under this scenario you pay a fee to the management team to try to beat the market. This is generally paid on an annual basis regardless of performance (it is taken out of your money invested with them so you don’t feel it coming out of your pocket once you invest). To justify the fees charged they need to earn a return that not only beats the index they are tracking against (varies as to what they are investing in) but also covers the fees they are charging you to invest. It is also important to understand that most active management funds tend to under perform their benchmarks.

However, there are funds that beat their benchmark, Warren Buffet’s Berkshire Hathaway has outperformed the market for decades. You also may have heard of the Magellan Fund known for Peter Lynch and one of the best performing mutual funds in the world (while it lasted). There will be funds that beat the indexes and these funds will bring in more dollars from investors because of it. There is also always someone who hits the jackpot on the slot machines but this doesn’t mean everyone is rushing to Vegas to play because most people understand the odds of winning are terrible. This, in my opinion, can be compared to trying to pick which active fund will be the big winner of the future.

“The S&P 500 outperformed more than 92% of large-cap funds over the last 15 years. Mid- and small-cap funds fared no better over the time period, with their benchmarks besting them 95.4% and 93.2% of the time, respectively.” -Fortune.com

One last point on active management is that some of the brightest minds in the world work for these funds. They are equipped with the best research and every tool possible to succeed and yet so often they come up short. So, if you are planning on investing on your own basically creating your own fund/portfolio be honest with yourself before you dive in. I don’t like to discourage anyone from being the next investing guru but I would advise you to use a small portion of your portfolio to begin testing out the waters so you don’t lose your hard-earned money. Personally, I enjoy picking individual stocks but I also limit myself to doing so with no more than 5% of my total portfolio.

Passive Investing

The second strategy is known as passive investing which implies that you take what the market is willing to give you, avoid paying large fees, and build your own portfolio using index funds. An index fund simply tracks the movement of a market. One of the most common indexes you might have heard of is the S&P 500. This index tracks 500 of the biggest companies in America, check out the holdings here. You will most likely recognize many names on this list because these are large companies that sell their products to millions of customers around the globe every single day, including you. When you buy an index that is tracking these companies you are getting a tiny sliver of ownership in every company on that list. You are not trying to pick what the best company will be in the group but instead are willing to accept the performance of all the companies in the basket.

There has been a big movement towards passive investment over the last decade, don’t blindly drink any Kool-Aid do your research before you start investing your hard-earned dollars. The data has sold me personally to use low cost index funds to invest. One of my favorite resources is bogleheads.org to help educate yourself on sound investing principals. In the world of finance there is always someone selling you something this group will not. Instead it is a group of investors that try to help each other and continue learning on their own path to financial freedom. I appreciate what Jack Bogle has done for the average investor and this group does a good job of summarizing these points.

After you decide what you are going to be investing in I think the bigger question to long term success becomes what your asset allocation will be, or what mix of investments will you own? Asset allocation and savings rates have been argued to be much more important then what you are invested in and I will address these in the future. Just remember to take the time to educate yourself before you invest in anything. If you don’t understand it, then don’t invest in it, because at the first sign of trouble you will panic and pull out your money which defeats the whole purpose. Congrats if you are just getting started investing working for a living is for suckas’, you are well ahead of the game!

What Are Your Thoughts?

  1. What do you invest in?
  2. Do you have your money with an active fund or do you invest actively for yourself?
  3. How long have you been investing and what are your opinions on the best things to invest in?
Spread The Wealth!

2 Comments on “Getting Started With Investing – Active Vs. Passive Management”

  1. What are some ways I can diversify my portfolio further once I’ve picked my investment vehicle and investment strategy?

    1. I would suggest drafting an IPS (Investor Policy Statement) stating what it is you are investing for. Then work backwards based on expected returns by asset class to build a portfolio that meets your risk vs. reward objectives. Often people just invest to “make money” instead of asking themselves why they are investing in the fist place and then making a plan to reach their goals.

      Based on your personal goals and time line you can bring together many asset classes in a cost efficient way. The main ones being equities, bonds, real estate, and various other alternatives. There are levels of diversifying within each asset class as well which I will write about soon.

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