Consider Seeking to Be – Not Beat – the Market
Bid. Buy. Offer. Option. Call. Cover. Sell. Short. Rally. Retreat.
No matter how fluently people speak “stock market,” most translate investing as action.
Little surprise. Stories of investors doing something dominate media coverage. Be it news or advice, the focus generally is on making things happen. And whether cause or effect, markets move each day based on the millions of exchanges between sellers and buyers.
One byproduct: broad familiarity with active investing. Such ongoing buying and selling in pursuit of trading gain is a course-long employed by many investors and investment managers. The strategy seeks performance by continuously monitoring information and then acting on it.
The objective of a traditional investment manager is to outperform a targeted benchmark. That’s certainly a worthy goal. However, it’s only one way to pursue long-term investment growth.
Can Less be More?
Passive investing, a strategy that is growing exponentially, adopts a different approach. Most often embodied in index-tracking mutual funds and exchange-traded funds (ETFs), the underlying strategy is contrary to active investing.
Passive investors seek long-term appreciation with minimal maintenance. Passive investing attempts to replicate, as closely as possible, the holdings and performance of an established market index.
An index is simply a set of securities representative of a broad market or a segment of a broad market. Bear in mind, because an index is unmanaged and unavailable for direct investment, its performance excludes expenses (such as for research, trading, administration, etc.) associated with the management of an actual fund.
Active investing aims to outperform a benchmark by monitoring, managing, researching, reviewing, buying, selling, allocating and the like. Such activities incur expenses. And as is true of any investment, despite all the management efforts and related outlays, investing involves risk, including possible loss of principal.
In contrast, passive investing generally minimizes management activities. It seeks to replicate a benchmark, not surpass it. So passive investing does only what is necessary to mimic the holdings of a specific index. This strategy often minimizes the expenses that accompany active management.
Why does that matter? Because every penny not spent on an investment’s fees and expenses can instead go toward its performance. And that’s a good place for those pennies.
A Different Way to Drive Performance
Think about passive investing like driving in rush hour traffic.
Some drivers actively jump from lane to lane trying to beat the traffic, only to discover that sometimes they’ve chosen a faster lane and other times a slower one. Other drivers simply go with the flow, passively sticking with one lane and spending less effort in the process. Traffic is what it is. All lanes go the same direction. Continually changing lanes can be tricky. And often, both drivers arrive at or around the same place at the same time.
The difference is what it cost to get there. Operating costs — gas, oil, maintenance, wear-and-tear — can add up when you own a car. Relative cost is also a consideration when investing. Research and trading carry expenses, so actively managed funds tend to cost more to run than passively managed ones that merely track an index.1 And costs reduce returns.
In short, a passive investment holds its lane. Because a market index isn’t available for direct investment, an index-tracking mutual fund or ETF attempts to mirror a specific index as closely as possible after accounting for all expenses. Thus, you should expect it to underperform its targeted benchmark by the amount of its expenses.1
Indexing Versus Active: What Makes Sense for You?
Considering the historic long-term direction of markets in general, an index-tracking passive investment doesn’t try to “beat” the market; it simply tries to “be” the market. And that can be a good thing.
The passive strategy is also known as a buy-and-hold strategy, a “set it and forget it” method and sometimes even called a “couch potato” approach. It requires patience, a well-diversified portfolio and a long-term outlook with the ability to ignore the latest “hot fund” or faddish investment strategy in favor of often boring benchmarks.
Of course, same as is true of active management, options for passive investing can and do vary widely. Investors need to understand their risk tolerance and investment goals as they pursue their targeted objectives. They should work with a financial professional who takes the time to learn and understand their personal situation. Doing so can help define needs and consider actions – or “non-actions” – most appropriate for the given circumstances.
What Fits an Individual’s Investment Personality?
Does the client not want to monitor markets and investments closely? Would the client prefer to minimize investment costs as much as possible? Is the client committed to remaining “in” the market, confident of its long-term direction?
Clients may want to consider which statements below best describe their general investment disposition. Use them as a starting point for relationship-building as you determine whether passive or active investing may be more appropriate.
|Passive Investing||Active Investing|
|The market is an ocean. I’m willing to ride its current.||The market can be a minefield. Navigating it requires skill and professional planning.|
|Expenses represent baggage. I try to travel as light as possible.||Expenses represent expertise. I travel with a knowledgeable guide who plots the path.|
|Benchmarks work for me. Trying to do better entails more risk than I can tolerate.||Benchmarks are baselines I hope to surpass. I’ll assume greater risk for greater potential reward.|
|My investment plan assumes tracking market averages over time.||My investment plan assumes outperforming market averages over time.|
|Consistently beating the market is difficult. Slow but steady appeals to me.||There are always examples of beating the market. Informed, strategic decisions appeal to me.|
1 Vanguard Investment Counseling and Research (“The Case for Index-Fund Investing” April 2013). Used with permission.
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